Stock Returns, Inflation and Macroeconomy: The Long- and Short-Run Dynamics

Abstract

We re-examine the inverse relationship between stock returns and inflation in the post- World War II period. Fama (1981) theorizes that the inverse inflation-stock return correlation is a proxy for the negative relationship between inflation and real activity. Geske and Roll (1983) argue that the inflation-stock return correlation reflects changes in government expenditures, real economic conditions and monetization of budget deficits. We test these hypotheses simultaneously using a multivariate vector-Error-Correction Model (VECM) proposed by Johansen and Juselius (1992, 1994). We find that both real activity and monetary fluctuations generate the contemporaneous correlation between stock returns and inflation. However, the Federal Reserve bank seems not to monetize Federal deficits, nor do government deficits appear to drive changes in real economic activity during the period examined. Thus, our results appear more compatible with Fama's explanation than that of Geske and Roll. More intriguingly, the sources of both real activity and monetary fluctuations are the long-run disequilibria of macroeconomy.