Academic journal article Atlantic Economic Journal

Common Stocks and Inflation: An Empirical Analysis of G7 and BRICS

Academic journal article Atlantic Economic Journal

Common Stocks and Inflation: An Empirical Analysis of G7 and BRICS

Article excerpt

Introduction

When the Fisher effect is applied to the stock returns/inflation relationship, it is suggested that stocks would move one-to-one with inflation, thus making stocks a hedge for inflation. Results of past research on the relationship between stock returns and inflation were mixed. Ongoing studies examine whether the two move one-to-one or imply that stocks are a hedge for inflation, or if the relationship is an inverse one, meaning stocks would not provide any protection against inflation. Overall, a section of the literature is concerned with the relationship between stock returns and inflation in different countries with different monetary and inflationary regimes, and other sections of literature are dedicated to testing theories put forth to explain the nature of the relationships.

In an attempt to understand this relationship and extend existing literature, this study proposes testing the Fisher effect in two groups of countries, the G7 group of low inflation industrialized countries (Canada, France, Germany, Italy, Japan, United Kingdom, and United States) and a group of relatively high inflation emerging countries including Brazil, Russia, India, China and South Africa (BRICS). By using two different groups of countries, the study examines if a one-to-one movement of the variables relates to the economy's inflation rate in the short-run and consumer price index in the long-run.

It is expected that if a country's inflation rate influences the short-run relationship between inflation and stock returns, then the results from the G7 group of low inflation countries should be different from the BRICS group of relatively high inflation countries. This article examines the short-run relationship between stock returns and inflation and uses cointegration and vector error correction models to study the long-run relationship between the consumer price index and stock prices.

Literature Review

Important to the stock return/inflation relationship is the Fisher effect (Fisher 1930), which, when generalized to this topic, suggests that stocks returns and inflation will move one-to-one. Some researchers have found a negative relationship between the two suggesting the theory does not hold in this context. Many economists have set forth theories as to why this negative relationship occurs.

The proxy hypothesis states that a negative relationship between stock returns and expected inflation is observed because stock prices and expected inflation react in opposite ways to changes in expected real economic activity. For example if real economic activity is expected to be high, stock prices rise, but the demand for money also goes up. If it is not matched by an equal increase in money supply, then inflation will decrease (see Fama 1981, Gallagher and Taylor 2002).

The demand for money is not the only factor inducing a negative relationship between stock returns and inflation; changes in the money supply can also produce a similar effect. That is, a fall in stock prices signals a drop in economic activity and government tax revenue. Given fixed expenditures, this leads to an expectation that the government will run a budget deficit, and may have to take inflationary measures to finance the deficit. In summary, a decrease in stock prices will be associated with an increase in Treasury bill rates because either the real interest rate and/or expected inflation would increase depending on whether the central bank partially or fully monetizes budget deficits (Geske and Roll 1983).

Another explanation was given by Kaul (1987), who noted that the negative relationship between stock returns and expected inflation in the post-war period in the U.S. could be explained by counter-cyclical monetary policy. He suggested that positive shocks to real output generate monetary tightening and vice versa. There are also those who have argued that higher rates of inflation tend to be more variable. …

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