This paper evaluates stock return predictability with inflation and output gap, the variables that 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. We evaluate economic significance of the stock return models and find that the models with Taylor rule fundamentals consistently produce higher utility gains than the benchmark models
