Real stock market returns and inflation: Evidence from uncertainty hypotheses

Abstract

This paper presents uncertainty hypotheses to explain the negative relationship between real stock returns and inflation. Testing the real stock return−inflation relationship based on data from 12 advanced countries indicates that real stock returns are negatively correlated with equity market volatility, which is positively correlated with inflation. These findings jointly support a negative correlation between real stock returns and inflation in the US and 11 other global markets. We reach comparable qualitative results using US monetary policy uncertainty innovation as an instrument to link real stock returns and inflation. One implication is that in addition to domestic inflation, the US inflation-induced equity volatility or change in monetary policy uncertainty reveals an incremental efficiency, providing new elements that modify Fama's (1981) hypothesis. The evidence suggests that US inflation-induced volatility or monetary policy uncertainty innovation profoundly impacts global stock markets.