Abstract
There is recent and strong evidence that nominal stock returns are independent of inflation. In what amounts to the same thing, when real stock returns are regressed on inflation the resulting estimated coefficient on inflation is negative and unitary. These two propositions are mathematically equivalent. The purpose of this paper is to show that the market stock return is also independent of expected inflation, as measured by the T-bill rate. Firstly, regressions of the equity premium on inflation produce invariably slope coefficients that are statistically insignificantly different from -1. The inflation variable on the right hand side of the regression picks up the sign and the magnitude of the T-bill rate in the equity premium on the left hand side of the regression. This is as expected because the T-bill rate is an unbiased predictor of the future inflation rate, or, in other terms, the T-bill rate is a proxy for expected inflation. Hence regressions of real stock returns on inflation are in substance the same as regressions of the equity premium on inflation, and in both cases nominal stock returns are independent of inflation, and of its expected proxy, the T-bill rate. Secondly, additional evidence is provided from regressions of stock market returns on the inflation rate and the T-bill rate taken together. The hypothesis that the sum of the two coefficients on these two variables is statistically insignificantly different from zero is strongly supported. Moreover, the joint null hypothesis that the first coefficient is equal to -1 and that the second coefficient is equal to +1 is also strongly supported. As a conclusion stock prices already reflect macroeconomic shocks and there is neither money illusion nor over and under adjustment on the part of investors.
Highlights
This paper has the purpose to study the relation between the equity premium and the inflation rate in the case of the United States
The intent is to show that (1) the sum of the coefficients on these two variables is zero and (2) the first coefficient is insignificantly different from -1 together with the second coefficient being insignificantly different from +1. This dual intent is corroborated and it is shown that the equity premium is always independent of the inflation rate even when different
If this premium is regressed over the inflation rate as long as the inflation rate and the T-bill rate are proportional to each other, the regression should produce a coefficient of -1 on the inflation rate similar to the demonstration in equations (1), and similar to the demonstration that follows:
Summary
When real stock returns are considered the coefficient on the inflation rate is insignificantly different from -1 in line with the fact that the inflation rate enters as a negative and as a unitary term in the construction of the dependent variable. The intent is to show that (1) the sum of the coefficients on these two variables is zero and (2) the first coefficient is insignificantly different from -1 together with the second coefficient being insignificantly different from +1 This dual intent is corroborated and it is shown that the equity premium is always independent of the inflation rate even when different.
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