A Reexamination of Real Stock Returns, Real Interest Rates, Real Activity, and Inflation: Evidence from a Large Data Set

Date01 August 2017
Published date01 August 2017
The Financial Review 52 (2017) 405–433
A Reexamination of Real Stock Returns,
Real Interest Rates, Real Activity, and
Inflation: Evidence from a Large Data Set
Paul M. Jones
Eric Olson
West Virginia University
Mark E. Wohar
University of Nebraska-Omaha
Using the informational sufficiencyprocedure from Forni and Gambetti (2014) along with
data from McCracken and Ng (2014), we update the results of Lee (1992) and find that his
vector autoregression (VAR) is informationally deficient. Tocorrect this problem, we estimate
a factor augmented VAR (FAVAR) and analyze the differences once informational deficiency
is corrected with an emphasis on the relationship between real stock returns and inflation. In
particular, we examine Modigliani and Cohn’s (1979) inflation illusion hypothesis, Fama’s
(1983) proxy hypothesis, and the “anticipated policy hypothesis.”
Keywords: informational sufficiency, FAVAR, stock returns
JEL Classification:G10
Corresponding author: College of Business and Economics, WestVirginia University,Morgantown, WV
26506; Phone: (304) 293-7879; E-mail: eric.olson@mail.wvu.edu.
We are grateful to the editor,two anonymous referees, and conference participants and discussants at the
2015 Annual Meeting of the Midwest Econometric Group, 2016 Society for Nonlinear Dynamics and
Econometrics symposium, and the 2016 Financial Management Association Annual Meeting for very
helpful comments and suggestions.
C2017The Eastern Finance Association 405
406 P.M. Jones et al./ The Financial Review 52 (2017) 405–433
1. Introduction
The emergence of large data sets over the past decade has allowed researchers
to incorporate more information in empirical analysis than ever before. Many rela-
tionships reported in previous studies could potentially be misleading or incorrect if
relevant information is missing. Structural vector autoregressions(SVARs) have been
standard for econometric analysis ever since first being introduced in Sims (1980).
However, a crucial assumption in any SVAR model is that all relevant information
(i.e., a sufficient number of variables) is accounted for within the VAR. Hansen and
Sargent (1991), Lippi and Reichlin (1993, 1994), and Chari, Kehoe and McGrattan
(2008) show that if all relevant information is not included, the VAR can lead to
incorrect conclusions. To test whether all relevant information is included in a VAR,
Forni and Gambetti (2014) propose an informational sufficiency test along with a
way to correct for a deficient VAR.
One relationship that has been explored extensively using SVARs is the rela-
tionship between real economic activity, inflation, and real stock returns. Originally,
Fama (1981, 1983), based on a money demand model, suggested a negative asso-
ciation between inflation and real economic activity in conjunction with a positive
association between stock returns and real economic activity leads to a spurious neg-
ative relationship between stock returns and inflation. Subsequently, manyempirical
studies have suggested that the observed negative stock return–inflation relation is
not a direct causal relation but rather reflects other fundamental relationships in the
economy (Lee, 1992). Another strand of literature suggests that the stock return–
inflation relationship depends on whether the source of inflation is derived from
supply or demand factors (Geske and Roll, 1983; Danthine and Donaldson, 1986;
Lee, 1989). The negative relationship between asset returns and inflation may exist
due to the source of inflation being related to nonmonetary factors such as real output
shocks (Danthine and Donaldson, 1986; Stulz, 1986; Marshall, 1992; Bakshi and
Chen, 1996).
Hess and Lee (1999) build on the SVAR approach in Lee (1992) and use a SVAR
model to identify aggregate demand and supply shocks that drive the stock return–
inflation relation. Aggregate demand shocks drive a positive relationship between
asset returns and inflation while aggregate supply shocks primarily result in a negative
relationship. Hess and Lee (1999) report that aggregate demand shocks dominate in
the pre-war period whereas aggregate supply shocks dominate in the post-war period.
Lee (2010), using a SVAR, extends the Hess and Lee (1999) two-regime framework
to demonstrate that the Modiglinani and Cohn (1979) inflation illusion hypothesis is
not compatible with pre-war data.
The primary aim of this paper is to update Lee’s (1992) seminal paper which
was one of the first to use a SVAR to examine the relationship between infla-
tion and asset returns. Using the informational sufficiency procedure of Forni and
Gambetti (2014) along with data from McCracken and Ng (2014), we update the
results of Lee (1992) using generalized impulse responses and generalized variance

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