Inflation Illusion and the Dividend Yield: Evidence from the UK

We report evidence that the UK dividend yield and expected inflation are positively correlated from 1965 to the mid-1990s, but negatively correlated subsequently. Using a commonly–used VAR-based procedure we find strong evidence that the positive correlation is caused both by inflation illusion and the effect of inflation on required rates of return. We find little evidence that it is caused by inflation rationally reducing expected real dividend growth. We find that Chen and Zhao’s (2009) criticism of the VAR-based procedure has little empirical relevance but that the procedure can be highly sensitive to the choice of data period.