Asset Pricing and Expected Inflation

This paper provides an equilibrium model in which expected real returns on common stocks are negatively related to expected inflation and money growth. It is shown that the fall in real wealth associated with an increase in expected inflation decreases the real rate of interest and the expected real rate of return of the market portfolio. The expected real rate of return of the market portfolio falls less, for a given increase in expected inflation, when the increase in expected inflation is caused by an increase in money growth rather than by a worsening of the investment opportunity set. The model has empirical implications for the effect of a change in expected inflation on the cross-sectional distribution of asset returns and can help to understand why assets whose return covaries positively with expected inflation may have lower expected returns. The model also agrees with explanations advanced by Fama [5] and Geske and Roll [10] for the negative relation between stock returns and inflation.     

The Inflation Hedging Characteristics of US and UK Investments: A Multi-Factor Error Correction Approach

Historic analysis of the inflation hedging properties of stocks has produced anomalous results, with stocks often appearing to offer a perverse hedge. This has been attributed to the impact of real and monetary shocks to the economy, which influence both inflation and asset returns. It has been argued that real estate should provide a better hedge: however, empirical results have been mixed. This paper explores the relationship between commercial real estate returns and economic, fiscal and monetary factors and inflation for US and UK markets. Comparative analysis of general equity and small capitalization stock returns is carried out with inflation divided into expected and unexpected components. The analyses are undertaken using an error correction approach. In the long run, once real and monetary variables are included, asset returns are positively linked to anticipated inflation but not to inflation shocks. Adjustment processes are, however, gradual and not within period. Real estate returns, particularly private market returns, exhibit characteristics that differ from those of stocks.

Inflation,real returns and capital investment

We find evidence for the hypothesis of Mundell (1963) and Tobin (1965) that the expected real return component of interest rates is negatively related to the expected inflation component. In the Mundell-Tobin model, the variation in expected real returns is caused by the variation in expected inflation. Our evidence suggests, however, that the variation in expected real returns is more fundamentally an outcome of the capital expenditures process. Equilibrium expected real returns vary directly with capital expenditures in order to induce equilibrium allocations of resources between consumption and investment. This positive relation between expected real returns and real activity, which comes out of the real sector, combines with a negative relation between expected inflation and real activity, which is traced to the monetary sector, thus inducing the negative relation between expected inflation and expected real returns predicted by Mundell and Tobin but explained in terms of a model much different from theirs.     

Asset Returns and Inflation in Response to Supply,Monetary, and Fiscal Disturbances

This paper identifies sources of asset returns (stock returns and interest rates) and inflation relations. We find that the relation between asset returns and inflation is driven by three types of disturbances to the economy. We interpret them as due to supply disturbances and two types of demand—monetary and fiscal—disturbances. In post-war U.S. data, supply and fiscal disturbances drive a negative stock return-inflation relation, whereas monetary disturbances generate a positive stock return-inflation relation. However, all three types of disturbances generate a negative interest rate-inflation relation. Depending on the interaction of the three types of shocks, we observe different correlations between asset returns and inflation in post- and pre-World War II U.S. data.     

The Asymmetric Response of Equity REIT Returns to Inflation

This paper posits that the failure of past studies to document a positive relationship between REIT (Real Estate Investment Trust) returns and inflation is an artifact of the empirical framework that has predominated in these studies. Applying a pooled estimation methodology to an expansive data set containing 195 publicly traded equity REITs for the period 1981–2002, the study documents a strong asymmetry in the response of equity REIT returns to inflation. Specifically, when expected and unexpected inflation are separated into positive and negative changes, results indicate that equity REIT returns rise in response to both increases and decreases in inflation. The evidence, which is partly contingent on the prevailing monetary policy environment, carries important policy implications for portfolio management and provides insights into the observed anomalous relationship between REITs and inflation.     

Nominal rigidities,asset returns,and monetary policy

Asset-return implications of nominal price and wage rigidities are analyzed in general equilibrium. Nominal rigidities, combined with permanent productivity shocks, increase expected excess returns on production claims. This is mainly explained by consumption dynamics driven by rigidity-induced changes in employment and markups. An interest-rate monetary policy rule affects asset returns. Stronger (weaker) rule responses to inflation (output) increase expected excess returns. Policy shocks substantially increase asset-return volatility. Price rigidity heterogeneity produces cross-sectoral differences in expected returns. The model matches important macroeconomic moments and the Sharpe ratio of stock returns, but only captures a small fraction of the observed equity premium.     

Dynamic Interactions among the Stock Market,Federal Funds Rate,Inflation, and Economic Activity

This paper examines the dynamic interactions among the equity market, economic activity, inflation, and monetary policy under three monetary policy regimes using bivariate and multivariate vector autoregressive cointegrating specifications. The bivariate results for the real stock returns‐inflation pair weakly support a negative correlation in the 1970s and 1980s. While the bivariate findings suggest a weak, negative relationship between real returns and the federal funds in the 1970s and 1980s, the multivariate findings strongly support short‐term linkages in the 1970s. There appears to be no consistent dynamic relationship between monetary policy and stock prices in that the relationship differs across monetary regimes.     

Real Activity, Inflation, Stock Returns, and Monetary Policy

We find that contractionary monetary policy shocks generate statistically significant movements in inflation and expected real stock returns, and that these movements go in opposite directions. Since positive shocks to output precipitate monetary tightening, we argue that the countercyclical monetary policy process is important in explaining the negative correlation between inflation and stock returns. Examining the 1979–1982 period, we find that monetary policy tightens significantly in response to positive shocks to inflation, and that the impact of monetary policy shocks on stock returns is negative and volatile. Therefore, we see evidence that an “anticipated policy” hypothesis is at work.     

REIT Returns and Inflation: Perverse or Reverse Causality Effects?

Contrary to the Fisherian theory of interest, previous studies document a negative relationship between REIT (Real Estate Investment Trust) returns and inflation. In this research, we re-examine this perverse inflation behavior by testing for the causal relationships among REIT returns, real activity, monetary policy, and inflation through a vector error correction model. Our results indicate that the observations of REIT returns as perverse inflation hedges are spurious. The observed negative relationship between REIT returns and inflation is in fact a manifestation of the effects of changes in monetary policies. These findings are consistent with Darrat and Glascocks (1989) evidence of monetary effects on REIT returns.     

Stock Returns,Inflation, and Economic Activity: The Survey Evidence

The primary purpose of this paper is the use of survey expectations data to study the empirical relationships between stock returns, inflation, and economic activity. In the course of this analysis and as a secondary purpose, the paper discusses general considerations involving the use of expectations proxies and makes recommendations for econometric techniques. The main empirical findings are: (1) Hypothesized relationships between expected economic activity and expected inflation do not in practice appear to be important in explaining the negative relationship between expected inflation and stock returns. (2) Nevertheless, the survey data do lend some support to the hypothesis of a quantity theory relationship between expected inflation and expected economic activity, holding constant monetary growth. (3) The cross-forecaster dispersion of economic activity forecasts, a proxy for real uncertainty, appears to be a significant determinant of stock returns. Inclusion of this variable eliminates the negative impact of expected inflation.     

Are common stocks a good hedge against inflation? Evidence from the Pacific-rim countries

We explore whether the observed real stock return–inflation relations in the U.S. and 10 Pacific-rim countries for the sample period of 1970–1997 can be explained by the interaction between real and monetary disturbances. Ten countries exhibit a negative relation between real stock returns and inflation. Malaysia is the only country that exhibits a positive relation. For nine countries, real output disturbances drive a negative stock return–inflation relation, while monetary disturbances yield a positive relation. In addition, real shock components appear to be relatively more important than monetary shock components for these countries, and as a result the observed relation between stock returns and inflation is negative. Neither the tax hypothesis nor the monetary regime hypothesis seems to be easily compatible with the diverse experiences of the Pacific-rim countries.     

Capital Gains, Dividend Yields, and Expected Inflation

One explanation for the negative relationship between short-horizon stock returns and inflation is that inflation proxies (inversely) for expected future real output. In this paper, I examine the possibility that inflation also proxies for variation in real price/dividend ratios (excess returns). I show that when the covariance between real price/dividend ratios and inflation is nonzero, the relationship between returns and expected inflation differs for the two components of returns: dividend yields and capital gains returns. My empirical evidence demonstrates that dividend yields and capital gains are related differently to expected inflation in U.S. and foreign markets.     

The Fiscal and Monetary Linkage between Stock Returns and Inflation

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.     

Stabilizing non-fundamental asset price movements under discretion and limited information

Inflation, output and interest rate stabilization are all potential central bank objectives. We explore whether monetary policy should respond to asset price fluctuations when they are driven by irrational expectational shocks to the future returns to capital. In our model, an optimistic shock to future returns generates both an increase in equity prices and physical investment. The increased investment is inefficient and, thus, a central bank optimally responds to this expectations shocks. This induces a trade-off between stabilizing nominal prices and non-fundamental asset price movements. We compare the optimal policy under different assumptions: full versus limited information and commitment versus discretion. If the central bank has limited information about whether an asset price movement has a fundamental or non-fundamental origin, then the central bank responds less aggressively to the non-fundamental exuberance shocks than under full information. Without commitment, a central bank responds more aggressively to non-fundamental exuberance shocks.     

COMMON STOCK RETURNS,EXPECTED INFLATION,AND THE RATIONAL EXPECTATIONS HYPOTHESIS

This paper provides empirical evidence that expected inflation has a cross-sectional impact on common stock returns. The study differs from others in that (a) the relation between stock returns and expected inflation is investigated in a two-factor asset pricing model, where the factors are the return on an equally weighted stock portfolio and the expected rate of inflation; (b) the estimation of the expected rate of inflation is based on the rational expectations hypothesis of Muth; and (c) a non-linear seemingly unrelated regression technique is employed to determine consistent and asymptotically efficient estimates. The joint hypothesis of the two-factor asset pricing model and rational expectations is not rejected in this study. It is found that the return on common stocks is significantly affected by expected inflation. Also stocks whose returns are positively correlated with expected inflation have lower expected returns.     

Real Stock Returns and Inflation

This paper develops the relation between the real rate of return on the stock market and changes in the price level using a multiperiod economy with production. The observed relation between real ex post stock returns and inflation is shown to be consistent with equilibrium in an economy with rational investors. The relation between expected real returns and expected inflation is shown to depend on the form of the economy's production function and on the form of investor preferences. When the production function exhibits stochastic constant returns to scale, the model explains the negative relation between expected real returns and expected inflation which has frequently been observed in empirical studies.     

Cross‐region and cross‐sector asset allocation with regimes

Cross‐region and cross‐sector asset allocation decisions are one of the most fundamental issues in international equity portfolio management. Equity returns exhibit higher volatilities and correlations, and lower expected returns, in bear markets compared to bull markets. However, static mean–variance analysis fails to capture this salient feature of equity returns. We accommodate the nonlinearity of returns using a regime switching model across both regions and sectors. The regime‐dependent asset allocation potentially adds value to the traditional static mean–variance allocation. In addition, optimal allocation across sectors provide greater benefits compared to international diversification, which is characterized by higher returns, lower risks, lower correlations with the world market and a higher Sharpe ratio.     

Common stock returns,real activity,money, and inflation: Some international evidence

This paper tests whether the negative relationship between real stock returns and inflation in the United States is in fact proxying for a positive relationship between stock returns and real activity variables in six major industrial countries over 1966–1979. Consistent with Fama's ‘proxy-effect’ hypothesis, we document a negative relationship between inflation and real activity and a positive one between real stock returns and real activity variables. Real activity variables dominate money growth rates and expected and unexpected inflation in explaining real stock returns. A puzzling result that still remains is the positive role of money and the negative role of expected inflation in explaining these real stock returns in all major industrial countries.     

An Empirical Evaluation of the Friedman Hypothesis of Inflation on Capital Asset Pricing

An empirical model incorporating the Friedman inflation uncertainty hypothesis is evaluated on capital asset pricing in conjunction with the covariance effect of the Fisher inflation hypothesis. The Fisher-Friedman capital asset pricing empirical model (FFCAPM) is compared to the capital asset pricing model (CAPM) and the Chen-Boness (C-B) model for explanatory power and significance over three periods. The FFCAPM performed better than the two competing models in explaining the variation in equity returns. The Friedman hypotheses of a positive economy-wide inflation adjustment and a negative inflation uncertainty impact are supported. A firm-specific inflation response of Fisher inflation covariance was also supported. These results indicate that empirical support for the Fisher effect may be limited given the normal testing procedure of simply adding an inflation term as in previous studies.     

Owner-occupied homes,income-producing properties,and REITs as inflation hedges: Empirical findings

New evidence on the correlation patterns of various real estate returns with inflation is presented. Returns on a wide array of real estate, nonresidential as well as residential, are investigated. Stock and bond returns are also analyzed for comparison purposes. Extensive heterogeneity is found in real estate return correlations with inflation. Nonresidential property returns are most strongly positively correlated with inflation, although the appreciation in owner-occupied homes is also positively associated with inflation. However, REIT returns tend to be strongly negatively correlated with inflation. In this respect, they look more like traditional stocks and bonds than any other type of real estate. Finally, new evidence on return correlations with energy prices is also presented. Nonresidential real estate performs best here, too, although no real estate asset fully compensates investors for adverse energy price shocks.