The Fiscal and Monetary Linkage between Stock Returns and Inflation

Abstract

Contrary to economic theory and common sense, stock returns are negatively related to both expected and unexpected inflation. We argue that this puzzling empirical phenomenon does not indicate causality.Instead, stock returns are negatively related to contemporaneous changes in expected inflation because they signal a chain of events which results in a higher rate of monetary expansion. Exogenous shocks in real output, signalled by the stock market, induce changes in tax revenue, in the deficit, in Treasury borrowing and in Federal Reserve "monetization" of the increased debt. Rational bond and stock market investors realize this will happen. They adjust prices (and interest rates) accordingly and without delay.Although expected inflation seems to have a negative effect on subsequent stock returns, this could be an empirical illusion, since a spurious causality is induced by a combination of: (a) a reversed adaptive inflation expectations model and (b) a reversed money growth/stock returns model.If the real interest rate is not a constant, using nominal interest proxies for expected inflation is dangerous, since small changes in real rates can cause large and opposite percentage changes in stock prices. THERE ISA WELL-documented but puzzling empirical relation between stock returns and inflation. Expected inflation, unexpected inflation, and changes in expected inflation are all negatively related to stock returns. See Fama and Schwert [12] and the less comprehensive but consistent work by Lintner [26], Jaffe and Mandelker [23], and Nelson [32]. We offer here an explanation for this phenomenon and present evidence supporting the explanation.The empirical results merit attention because they appear to be in conflict with both economic theory and common sense, according to which stock returns should be positively related to both expected and unexpected inflation. A positive * Graduate School of Management, University of California, Los Angeles. We are grateful for many helpful conversations with Brad Cornell, for the assistance of Ted Lloyd of the UCLA macroeconomic forecasting group in assembling data, for the assistance of Winston Cheong in computations, and for comments and suggestions from Eugene Fama, Kenneth French, David Mayers, Bruno Solnik, Sheridan Titman, and from workshop participants at Claremont Graduate School, Tennessee, Toronto, and UCLA (Economics). We owe a particular debt to Michael Brennan for many helpful editorial and substantive suggestions. However, no one named above necessarily agrees with or is responsible for the resulting contents of this paper. 2The Journal of Finance stock price reaction to unexpected inflation is suggested by the traditional idea that equities are "hedges" against (unanticipated) inflation because they represent claims to real assets. Stock returns should be positively related to expected inflation according to the Fisherian theory of interest; the nominal expected return on any asset equals real interest and a real risk premium (if appropriate), plus expected infla...

Do stock market returns predict changes to output? Evidence from a nonlinear panel data model

“…Fischer and Merton (1984), using annual US data over the period , found that the stock market contributes substantially to the prediction of the growth rate of real GNP. Barro (1990) arrived at similar conclusions regarding US investment over several sample periods: 1891-1914, 1921-1940& 1948-1987. Geske and Roll (1983, along with Fama (1990) and Schwert (1990), also found strong relations between stock returns and real activity.…”

Determinants of Stock Market Performance

“…Previous studies like Fama (1981), Geske& Roll (1983, and Chen, Roll, & Ross (1986), among others, have indicated a link between increased volatility in the stock market and movement of macroeconomic variables. Therefore, it is important to explore similar in Nepalese stock market.…”

“…This may reduce the tendency of investors to borrow and invest in stocks, and raises the cost of doing business and hence affects profit margin. On the contrary, lower interest rates resulting from expansionary monetary policy boosts stock market (Fama, 1981;Geske& Roll, 1983) and contrary to this Kuwarnu& Victor (2011), and Chia & Lim (2015) revealed the positive relation.…”

Responses of the Warsaw Stock Exchange to the U.S. Macroeconomic Data Announcements

“…Fama [15] found that the growth rate of industrial production has a strong contemporaneous link with stock returns. Geske and Roll [20], Fama [16] and Tainer [43] assumed a similar positive relationship taking into account the impact of industrial production on future cash flows. Chen et al [7] indicated that future growth in industrial production was a significant factor which affected stock returns.…”