The complex relationship between inflation and equity returns

ABSTRACT

Purpose>To investigate the complex relationship between inflation, inflation uncertainty and equity returns.Design/methodology/approach>This paper uses a bivariate VARMA, GARCH-in-mean, asymmetric BEKK model to investigate the relationship between inflation, inflation uncertainty and equity returns.Findings>Using monthly inflation and equity returns data for the G7 and EM7 economies, we find that the effects of inflation and inflation uncertainty on equity returns vary across countries.Research limitations/implications>The mixed evidence we find potentially reflects the changing dynamics, policy regimes, economic shocks and country-specific factors (such as differences in the financing patterns of enterprises and the legal and financial environments) across the G7 and EM7 countries.Practical implications>We contribute to the empirical literature in the following ways. First, we rely on a wide sample of countries, including both developed and emerging economies. Second, we extend previous research by estimating a GARCH-in-mean model of monthly equity returns in which both realized returns and their conditional volatility are allowed to vary with inflation. Previous articles that studied the relationship between inflation and stock market returns generally sought time-invariant effects of inflation on stock returns.Social implications>The paper helps to reconcile the divergent results of previous empirical studies and distinguish between alternative explanations of the relationship between inflation and equity returns.Originality/value>Our study provides an improved comprehension of the ambiguous relationship between inflation, inflation uncertainty and equity returns under various central bank mandates and different levels of central bank independence. The mixed empirical evidence across countries we present provides insights for the macroeconomic models that consider the relationship between uncertainty and macroeconomic performance as a fundamental building block. Therefore, our empirical study calls for further work on the relationship between inflation, inflation uncertainty and equity returns.