- A new IMF working paper revisits the relationship between stock returns and inflation, specifically under different monetary policy regimes.
- Equity index movements of 77 countries over 35 years reveal real stock returns decline when inflation rises, making equities a poor hedge against inflation in the short run.
- A country’s prevailing monetary policy regime partly drives this correlation, with inflation-targeting economies typically seeing stock markets respond more negatively to inflation.
- In recent years, however, equities have become less sensitive to inflationary news in countries where the policy rate is close to zero.
Many have documented that equities are poor inflation hedges in the short term. That is, as inflation rises, the growth in real stock returns falls. In 1979, Franco Modigliani and Richard Cohn put it down to ‘money illusion’, but several alternative hypotheses exist. A new IMF working paper explores how a country’s monetary policy regime affects the stock return-inflation relationship. It finds:
- If a country pursues more countercyclical monetary policy, i.e., ‘leans more heavily against the wind’, stock markets react more negatively to inflation, especially in advanced economies.
- The negative relation between stock returns and inflation is particularly noticeable under inflation-targeting regimes, while stock returns pay no attention to inflation under exchange rate anchoring.
- When the zero lower bound (ZLB) constrains the policy rate, markets generally disregard inflation and monetary policy cyclicality, i.e., the stock return-inflation relationship is no longer significant.
Past Evidence Shows Stocks Are a Poor Hedge Against Inflation
The link between inflation and equity returns is complex. Irving Fischer’s (1930) classic view is that expected nominal returns on an asset should equal the expected real returns plus expected inflation. In principle, stocks, which represent claims on real output, should be a good hedge against inflation because business revenues should track consumer prices. Indeed, over the long haul, stocks beat inflation.
In the short run, however, researchers find a negative correlation between real stock returns and inflation in developed countries. One possible explanation could relate to a central bank’s policy regime: when inflation rises, countercyclical monetary policy will lift its policy rate. This lowers the net present value of stocks, increases the borrowing costs for firms, increases the attractiveness of competing assets such as bonds and deposits, dries up liquidity in the stock market, and puts downward pressure on stocks.
Several other hypotheses have also offered explanations:
- Money illusion hypothesis: investors fail to understand the effect of inflation on nominal dividend growth rates and so extrapolate historical growth rates even in periods of changing inflation. This implies stocks are undervalued when inflation is high and overvalued when low.
- Proxy-effect hypothesis: the negative stock return-inflation relationship is induced by negative relationships between real activity and inflation, which both money demand theory and the quantity of money theory explain in turn.
- Tax hypothesis: US tax laws mean that, when prices rise, real profits net of corporate income tax vary inversely with inflation. In essence, as inflation rises, the effective tax rate on corporate income increases, lowering the share price.
- Sticky discount rate hypothesis: evidence from Katz et al. (2017) shows that when local inflation increases, local investors earn lower real returns on local stocks. They believe this is because investors are too slow to update the inflation expectations in discount rates, i.e., sticky nominal discount rates.
Data and Methodology
The IMF paper’s authors examine the stock return-inflation relationship in a quarterly panel of 71 advanced and emerging economies over 35 years. They investigate how the relationship unfolds in different monetary policy regimes, focusing on cyclicality, framework and flexibility (Chart 1). Typically, past research has focused only on developed countries in which central banks follow countercyclical, inflation-targeting regimes and that are unconstrained by the ZLB.
The panel dataset includes equity index and VIX data from Bloomberg, CPI data from the IMF, inflation forecasts from Consensus Forecasts, industrial production from Thomson Reuters/IMF, M2 from Haver Analytics, financial sector risk ratings from the ICRG, and Treasury yields from the Board of Governors of the Federal Reserve System. Overall, the panel is unbalanced (not all countries have the same number of observations), covering 33 advanced economies and 38 emerging economies from 1980 to 2015.
Real stock returns are most relevant to investors. Therefore, the authors look at the relationship between the logs of YoY real stock returns (deflating nominal returns by CPI) and inflation, controlling for the above variables. To address the econometric issues of serial correlation, heteroskedasticity, and cross-sectional dependence, the authors apply the Driscoll-Kraay standard error estimators.
Markets Respond Negatively to Inflation Spikes in DM Economies
The authors find a strong negative correlation between real equity returns and inflation for most sample countries, especially those with low average inflation (Chart 2). Specifically, a 1pp increase in expected inflation leads to a 0.14pp decrease in real stock returns. This increases to 0.45pp when the inflation rise is unexpected. Through Fischer’s lens, the correlation should be zero, such that nominal returns are completely driven by inflation.
Dividing the sample by income, the relationship is most negative in advanced economies. A 1pp rise in the growth rate of expected inflation lowers real stock return growth by 6.24pp. Meanwhile, in emerging economies, there is no statistically significant evidence that a negative relationship between higher inflation and lower stock returns exists.
Monetary Policy Cyclicality
The paper’s main innovation is to explore how this core relationship alters depending on the monetary policy regime. The authors start by looking at cyclicality. A monetary policy is countercyclical if an authority hikes rates to combat inflation. It is procyclical if the authority lowers the policy rate when inflation increases. Historically, they find advanced economies adopt more countercyclical measures – identified by a positive correlation between the cyclical components of real output and policy rates – while EMs have been more procyclical (Chart 3).
Denoting countries that use countercyclical monetary policy measures by a ‘1’ in the above analysis allows the authors to see how the stock return-inflation relationship alters by cyclicality. They find the correlation, on average, becomes more negative relative to the baseline. Also, a non-linear relationship exists where the more central banks try to tackle inflation, the more negatively stock returns respond. This result holds in both advanced and emerging markets but is greater in the former.
Monetary Policy Framework
The authors consider four monetary policy frameworks: exchange rate anchor, monetary aggregate target, inflation targeting and other frameworks. Under an exchange rate anchor regime, where the monetary authority focuses solely on stabilising the exchange rate, the negative correlation between real returns and inflation becomes insignificant. In other words, the monetary policy framework does not explain the negative stock return-inflation correlation.
Meanwhile, for inflation-targeting countries, the relationship is more pronounced compared with the baseline results. On average, real stock returns respond more negatively to inflation, and this is true in both advanced and emerging markets. Yet this is untrue for inflation-targeting countries that lack credibility. Otherwise stated, markets are more sensitive to inflation in countries that maintain inflation within their target bands most of the time.
Monetary Policy at the Zero Lower Bound
The authors compare stock market reactions to inflation under normal times and ZLB periods. While there are only a limited number of observations during which the policy rate has been close to zero, they find the relationship between returns and inflation becomes insignificant. This may be because a positive inflation spike can be seen as good news during ZLB periods.
The authors bring some clarity to the relationship between stock market returns and inflation. Broadly speaking, higher inflation hurts real returns in the short run, especially in countries that have historically been good at controlling inflation. By definition, this means price rises are much more likely to negatively affect equities in advanced economies.
Interestingly, however, the relationship tends to break down when the ZLB constrains countries. With inflation currently running high in many advanced economies whose policy rates are close to zero, the historically poor inflation-hedging properties of equities may no longer apply.
For a more off-the-beaten-path discussion on the battle against inflation, listen to our recent podcast on farmland as an inflation hedge. We also recently spoke with Lindsay Politi on the components of inflation and strategies to hedge against inflation.
Zhang Z., (2021), Stock Returns and Inflation Redux: An Explanation from Monetary Policy in Advanced and Emerging Markets, IMF, (Working Paper No. 2021/219), https://www.imf.org/en/Publications/WP/Issues/2021/08/20/Stock-Returns-and-Inflation-Redux-An-Explanation-from-Monetary-Policy-in-Advanced-and-463391
Sam van de Schootbrugge is a Macro Research Analyst at Macro Hive, currently completing his PhD in international finance. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector.