The variability of inflation and real stock returns

Abstract

While a negative correlation between inflation and real stock returns has been well documented, the cause of this relationship has been the subject of considerable controversy. The most plausible causal interpretation is the variability hypothesis which points to a chain from higher inflation to greater variability and uncertainty to depressed economic activity, hence generating a link between inflation and expected returns. The previous studies have not found support for this hypothesis, however, and Fama's noncausal proxy hypothesis has gained considerable currency. It is argued that there have been serious methodological problems with the previous tests of the variability hypothesis. When these are corrected, we find strong support for the causal variability hypothesis in the post war data for the United States.