Stock returns and inflation revisited: An evaluation of the inflation illusion hypothesis

Several hypotheses have been proposed to explain the stock return–inflation relation. The Modigliani and Cohn’s inflation illusion hypothesis has received renewed attention. Another hypothesis is the two-regime hypothesis. We reexamine these hypotheses using long sample data of the US and international data. We find that the inflation illusion hypothesis can explain the post-war negative stock return–inflation relation, but it is not compatible with the pre-war positive relation. Using a structural VAR identification method, we show that there are two regimes with positive and negative stock return–inflation relations not only in each period of the US but also in every developed country we consider. This seems inconsistent with the inflation illusion hypothesis that predicts only a negative relation.