Movements in the Equity Premium

REAL BOND RATES increased sharply in the early 1980s and have remained high since. Even today, in the midst of a world recession and low U.S. and Japanese short real rates, long real rates throughout the world remain unusually high. Pessimists trace the high rates to a decrease in the supply of capital. They point to the long string of fiscal deficits and to the decline in household saving and warn of the disappearance of thrift. Optimists trace the high rates to an increase in the demand for capital and point to the high profit opportunities unleashed by the conservative revolutions of the 1980s. These factors have surely played a role. But there is more at work, for consider the following fact: while expected real rates on bonds have indeed been high for more than a decade, expected real rates of return on stocks appear, if anything, to have declined slightly. This suggests that the focus should not only be on the increase in bond rates, but also on the simultaneous increase in bond rates and decrease in equity rates: on the decrease in the equity premium. This is the focus of this paper. In the first section, I construct expected real rates on shortand medium-term bonds for a number of OECD countries from 1978 on, using commercial forecasts of inflation available at the time. I stop short of constructing expected real rates of return on stocks, but by looking at the underlying components, I argue that the 1980s were indeed associated with a sharp decrease in the equity premium.