Measuring the equity risk premium

We use surveys of economic forecasts to derive a forward-looking estimate of the US equity risk premium (ERP) relative to government bonds. Our ERP measure helps predict short-term relative returns between stocks and bonds. Over the period we studied, low readings of the ERP tended to adjust back to the mean via a rally in the bond market rather than a fall in stock prices. We do not generalise from this result, however, as our sample period is characterised by strong trends of falling inflation and rising stock prices. Our estimate of the expected ERP — averaging just over 2 per cent — is markedly lower than the premium that historical studies show has been realised. Data from the UK paint a similar picture to the US experience.