Abstract
The widely observed negative correlation between inflation and real equity returns is, in part, explained by the proxy hypothesis (Fama, 1981) according to which the negative correlation is simply induced by inflation and real equity returns reacting oppositely to news about future real output growth. However, controlling for output growth does not fully eliminate this negative correlation. I argue that agency costs increase with the relative price variability (RPV) that tends to accompany inflation, and find evidence that variations in RPV explain much of the negative relationship between inflation and real equity returns that persists after controlling for output growth. Keywords: Inflation; Relative price variability; Agency costs JEL classification: E31; E44; D82
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