Stock return predictability and Taylor rules

Abstract This paper evaluates stock return predictability with inflation and output gap, which typically enter the Federal Reserve Bank's interest rate setting rule. We introduce Taylor rule fundamentals into the Fed model that relates stock returns to earnings and long‐term yields. Using real‐time data from 1970 to 2008, we find evidence that the Fed model with Taylor rule fundamentals performs better in‐sample and out‐of‐sample than the constant return and original Fed models. Economic significance tests indicate that the models with Taylor rule fundamentals consistently produce higher utility gains than the benchmark models. Though the performance of the Taylor rule model weakens when we extend the sample to include the post‐2008 period characterized by prolonged zero lower bound episodes, it still outperforms the benchmark models.