Why Does Aggregate Earnings Growth Reflect Information about Future Inflation?

Abstract

ABSTRACT We propose two explanations for the previously documented relation between aggregate earnings growth and future inflation: one based on firms changing their investment in response to earnings growth, and the other based on consumers varying their consumption in response to wealth effects of profitability growth. As the supply of goods and services is relatively inelastic in the short run, our arguments imply that changes to near-term demand for investment (consumption) will affect the prices of investment (consumption) goods and services. Consistent with the investment-based argument, we find that profitability changes predict investment and Producer Price Index (PPI) shifts in subsequent quarters. Our analyses also reveal that aggregate earnings growth predicts future investment and PPI forecast errors. We find, at best, weak evidence for the consumption-based link between aggregate earnings growth and future inflation.