Common stock returns, expected inflation, and the rational expectations hypothesis

This paper provides empirical evidence that expected inflation has a cross‐sectional impact on common stock returns. The study differs from others in that (a) the relation between stock returns and expected inflation is investigated in a two‐factor asset pricing model, where the factors are the return on an equally weighted stock portfolio and the expected rate of inflation; (b) the estimation of the expected rate of inflation is based on the rational expectations hypothesis of Muth; and (c) a non‐linear seemingly unrelated regression technique is employed to determine consistent and asymptotically efficient estimates. The joint hypothesis of the two‐factor asset pricing model and rational expectations is not rejected in this study. It is found that the return on common stocks is significantly affected by expected inflation. Also stocks whose returns are positively correlated with expected inflation have lower expected returns.