In our new working paper, we study why professional forecasters disagree about future stock returns, even when they observe the same macroeconomic signals. We find that one reason is that they have different narratives about how macroeconomic variables affect the stock market. Holding the information environment and signal noise constant, we show that these narratives, or mental models, drive disagreement among professional forecasters. In late 2022, when euro area inflation had peaked above 10%, and disagreement about 2023 inflation reached an all-time high, we asked financial market experts not only what they expect for inflation and returns, but also why, and through which mechanisms, inflation affects returns. Using open-ended questions, we elicited the narratives they use to link inflation to equity returns. Almost all share the same underlying economic model that stock prices are discounted future cash flows. But they differ on the channel they consider most relevant. Two-thirds point to monetary policy and discount rates as the link between inflation and returns, implying a negative return-inflation relationship. A quarter focus on profit margins and whether firms can pass rising costs on to customers. Then we ran a randomized information experiment. Forecasters shown a Bundesbank inflation projection revised their inflation expectations toward it. Whether that translated into revised return expectations depended on the narrative they held. The narratives also affect behavior. In a hypothetical portfolio task, forecasters expecting disinflation and less restrictive monetary policy allocated 65% to the DAX. Those expecting persistent inflation allocated around 20 percentage points less. The takeaway for policymakers is that a common signal does not produce common beliefs when people interpret it through different mental models. This matters for how monetary policy transmits and for how central banks communicate. Whereas two-thirds of professionals in our sample see a negative link, households tend to associate higher inflation with higher stock returns. Central banks can address this by making their own narrative and alternative explanations explicit. Publishing scenarios alongside a baseline, as the Bernanke Review recommends, does exactly that.
Comments are very welcome. This project is joint work with Christian Conrad and Michael Weber, as well as Frank Brückbauer, who implemented the survey. We thank the ZEW – Leibniz-Zentrum für Europäische Wirtschaftsforschung for including our questions in the ZEW Finanzmarkttest. I look forward to presenting the paper at the Banco de México and Banca d’Italia in November, and at the American Finance Association (AFA) Annual Meeting in Washington, D.C., in January.
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