Inflation, Inflation Risk, and Stock Returns

Abstract

This paper investigates the empirical relation between inflation and stock returns in ten industrialized countries, with a focus on the implications for links between inflation and the macroeconomy. The stock return decomposition of Campbell and Shiller (1988) is used to determine the extent to which the negative contemporaneous stock return associated with a positive inflation surprise is due to (a) lower future real dividends and (b) higher future required real equity returns. The empirical results suggest that generally higher inflation is associated with both lower real dividends and lower required real equity returns in the future. The evidences favors corporate tax-related theories (e.g. Feldstein (1980))--in which distortions in the tax system cause an increase in inflation to raise the firm's effective cost of capital relative to the return earned by investors in the firm--relative to the "risk premium story" that has been credited to Tobin (1958). However, for the United States and the United Kingdom, estimates of the arbitrage pricing theory (APT) model with a conditionally heteroscedastic inflation risk factor suggest that inflation may have increased the average real cost of equity capital by as much as fifty basis points.