Inflation and stock prices.

• Author: Aburachis, A.T.
• Position: Report

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1. INTRODUCTION

   An accepted proposition is that stock prices can be expected, in the long-run static equilibrium, to rise in proportion to the increase in the price level and thus provide a hedge against the loss of purchasing power due to inflation (see 14). However, a large number of empirical studies show that real stock returns are negatively related to inflation (see 13). In this paper we show how theory versus empirical evidence based on co-integrated vector autoregression can resolve the controversy relating to stock prices and inflation.

   The paper is organized as follows:

   Section two briefly reviews the literature dealing with inflation and stock prices. Section three explores the relationship between stock prices and inflation. The final section concludes. The empirical results are presented as Appendices A, B, and C.

2. LITERATURE REVIEW

   The empirical finding that stock returns are inversely related to inflation rates has generated a significant debate in the finance literature (see 7). Modigliani and Cohn (1979) attribute the real effects of inflation to the existence of collective money illusion. Feldstein (1980) argued that inflation lowers stock prices because non-neutralities in the tax treatment of inventory and depreciation charges cause inflation to lower after tax profit. Fama argues that the negative inflation stock returns relationship is generated by a positive causal link between real output and stock returns coupled with an inverse correlation between real output and inflation (see Fama, 1990). According to Fama, the statistical relationship between inflation and stock returns should disappear once the effect of real output is controlled for. Using survey data to measure expectations, Coate and Vanderhoff (1986) present empirical evidence in support of Fama's view. They find that both anticipated and unanticipated inflation were insignificant in a stock return regression that included actual and surprise output growth (see also Fama, 1981). Caporale and Jung (1997) use a three equations model using time series proxies for expectations, and they reverse Fama's results. Campbell and Vuolteenado (2004), review several models depicting the relationship between stock returns and inflation and on the basis of their preferred model they produce evidence in support Modigliani and Cohn's hypothesis. Boudoukh and Richardson (2001) model the relationship between inflation and stock returns using an instrumental variables approach. They chose instruments (past inflation rates and short and long term interest rates) that have theoretical support as measures of ex- ante inflation. Their long horizon data suggest that stock returns and inflation are positively related. More recently, Karagianni and Kyrtsou (2011) argue that all of the previous studies are based on the assumption of linear dependence between stock returns and inflation. They suggest that the relation between stock returns and inflation may be more complex leading them to apply non-linear methods to study the dynamics between stock returns and inflation. They use what is called Recurrence Quantification (Webber and Zbilut, 1994). They also test for non-linear causality introduced by Diks and Penchenko (2006). They conclude that the use of non-linear methods suggests the existence of a negative relationship between stock returns and inflation.

3. STOCK PRICES AND INFLATON

   In this section the theory that states, that, in the long-run stocks are a good hedge against inflation is confronted directly by ascertaining whether stock returns and inflation share a common stochastic trend. Theory states that two time series with stochastic trends can move closely over the long-run, so that they appear to have the same trend component; that is, they...