Equity Market Valuation - Fed Model

[Ipad]

This should be really basic, but it’s driving me crazy that I can’t get my head around this.

The third criticism for the Fed model is that it compares a real variable (the index) to a nominal variable (treasury yield). Why is the index a real variable when inflation changes are not included? this is the text from schweser:

“The yield on a treasury is adjusted to incorporate changes in inflation and is thus considered nominal. The earnings yield will not automatically adjust to incoporate changes in inflation and could be considered real”

Am I reading this wrong? Help!

[cpk123]

nominal = real + inflation.

since index does not include inflation - it is a real variable.

But treasury yield does include effect of inflation - so it is a nominal variable.

[Ipad]

thanks!

[Screaming_Eagle]

@Ipad

This should be really basic, but it’s driving me crazy that I can’t get my head around this.

The third criticism for the Fed model is that it compares a real variable (the index) to a nominal variable (treasury yield). Why is the index a real variable when inflation changes are not included? this is the text from schweser:

“The yield on a treasury is adjusted to incorporate changes in inflation and is thus considered nominal. The earnings yield will not automatically adjust to incoporate changes in inflation and could be considered real”

Am I reading this wrong? Help!

[Screaming_Eagle]

The Inflation criticism of the Fed model is that it IGNORES inflation because it compares a real variable, the earnings yield (which is a ratio based on current period prices), to a nominal variable, the Treasury yield (reflective of the expected rate of inflation). Current prices are always reflected in the index since it adjusts based on all information including price changes (inflation)