The Effect of Inflation on Stock Prices | Pocket Sense
The analysis here indicates that this inverse relation between higher inflation and lower share prices during the past decade was not due to chance or to other. This thesis examines relationship between inflation and stock prices in Thailand as well as investigates impact of specific events i.e. Tsunami and global. The relationship between stock prices and the inflation can be either negative or positive, depending on the strengths of various theoretical channels at work.
Theoretically, inflation should not affect stock prices because companies can simply raise their prices to make up for the increased cost to produce goods and services. In reality, companies competing globally cannot raise their prices for fear of losing business to competitors.
These companies are negatively affected by inflation. Investors must understand the importance of inflation to stock prices to know the impact inflation will have on their investments. Tips Generally speaking, high inflation can negatively impact a company's bottom line and, consequently, their stock price. Assessing Corporate Profits Inflation negatively affects corporate profits.
Stock prices are a direct reflection of corporate net earnings. Many businesses are not able to change their prices to reflect increased cost. As more stuff is being created and sold in the economy, the demand for raw materials and workers increases. Besides pushing up prices, this can also result in higher wages. This is where we are now. If left unchecked, inflation could spike, which would likely cause the economy to slow down quickly and unemployment to increase.
This is where the Federal Reserve steps in. So before the economic party gets out of hand and stagflation takes hold, the Fed steps in to calm things down by increasing the cost of borrowing in an effort to gradually slow the economy rather than let it crash and burn.
Think of the Fed as the sensible person telling everyone to go home at midnight instead of partying until the early hours. Is the party over? Back to the current turmoil. In other words, inflation is warning sign that an economic slowdown is coming — whether gradually executed by the Fed or abruptly by a spike in inflation.
So if all of this is understood, why did the market crash? Investors, naturally, want to stay at the party as long as they can. Thus the market tanks. This is why a market can appear to be doing great and then suddenly fall at the first hint of inflation.
This is an updated version of an article originally published on Feb. He examined the two questions. First, how does inflation stock market volatility estimated by using nominal stock return series.
Second, does the relation differ between countries with different rates of inflation. The Canada and Turkey data were selected for comparison on the basis of their inflation level. The reason of selected countries because Turkey was an emerging market country with a high inflation rate and Canada a developed country with a low inflation rate.
The results suggests that the higher the rate of inflation, the higher the nominal stock returns consistent with the simple Fisher effect.
The result showed the rate of inflation was one of the underlying determinants of conditional stock market volatility particularly in a highly inflated country like Turkey.
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The variability in the inflation rate had a stronger impact in forecasting stock market volatility in Turkey than in Canada. Choudhry investigated the relationship between stock returns and inflation in four high inflation Latin and Central American countries: Argentina, Chile, Mexico and Venezuela during s and s.
There were two distinct ways to define stocks as a hedge against inflation, First, a stock was a hedge against inflation if it eliminates or at least reduces the possibility that the real rate of return on the security will fall below some specific floor value.
Secondly, it was a hedge if and only if its real return is independent of the rate of inflation. The result showed a direct one-to-one relationship between the current rate of nominal returns and inflation for Argentina and Chile. Further tests were conducted to check for the effects of the leads and lags of inflation. Evidence of a direct relationship between current nominal returns and one-period inflation was also found.
Results also show that significant influence on nominal returns was imposed by lags but not by leads of inflation.
Why does inflation make stock prices fall?
This result backs the claim that the past rate of inflation may contain important information regarding the future inflation rate. These significant results presented may show that a positive relationship between stock returns and inflation is possible during short horizon under conditions of high inflation. Boucher considered a new perspective on the relationship between stock prices and inflation, by estimated the common long-term trend in the earning—price ratio and inflation.
The study focus on the subjective inflation risk premium explanation by considering a present value model with a conditional time-varying risk premium and estimate the common long-term trend in the earning—price ratio and actual inflation. The study found that these deviations exhibit substantial out-of-sample forecasting abilities for excess stock returns at short and intermediate horizons. The results presented indicate that the earning—price inflation ratio has displayed statistically significant out-of-sample predictive power for excess returns over the post-war period at short and intermediate horizons.
The results are ambivalent concerning the efficient market hypothesis. Rapach measured the long-run response of real stock prices to a permanent inflation shock for 16 individual industrialized countries by using recent developments in the testing of long-run neutrality propositions. Under long-run inflation neutrality, an exogenous increase in the trend rate of inflation trend rate of money stock growth will have no long run effect on real stock prices.
However, some well-known theories suggested that an increase in trend inflation can bring about a long-run decrease in real stock prices. The result found little plausible evidence for a negative long-run real stock price response to a permanent inflation shock in the countries to assume that the contemporaneous decrease in inflation in response to a productivity shock and the liquidity effect were large.
The study also show the evidence that the long-run real stock price response to a permanent inflation shock was positive in a number of industrialized countries.
The structural bivariate VAR approach found that a permanent inflation shock significantly increases long-run real output levels in some relatively low-inflation industrialized countries Austria, Finland, Germany, and the United Kingdom. A long-run increase in real output should permanently increase anticipated earnings and thus real stock prices. The study found evidence against a long-run Fisher effect with respect to nominal interest rates on short-term government bonds for a number of industrialized countries Belgium, Canada, France, Germany, Ireland, Netherlands, United Kingdom, United States.
More specifically, the nominal interest rates typically increase less than one-for-one with inflation in the long run in response to a permanent inflation shock and thereby lowering real interest rates in the long run. Using a trivariate structural VAR framework, Rapach in press also finds that the long-run real interest rate typically falls in response to a permanent inflation shock for a large number of industrialized countries.
A lower long-run real interest rate on risk-free bonds should also increase long-run real stock prices by lowering the rates at which anticipated earnings were discounted. Khil and Lee observed real stock return and inflation relations in the U. In the study, they document a negative real stock return and inflation correlation in nine Pacific-rim countries as well as in the U.
However, Malaysia was the only country that exhibits a positive relation between real stock returns and inflation. Thus their study provided an empirical framework that attempts to disentangle the sources of these correlations. There were several reasons that they were interested in the stock return and inflation relation in the Pacific-rim countries. First, it was become more important to understand financial markets in Asian countries.
Second, while the U. Fourth, monetary authorities and their policies in most Asian countries tend to be more prone to political influence than in the U. Fifth, one of the hypotheses that explain the negative correlation between stock returns and inflation was the tax hypothesis.
But Malaysia experiences a positive correlation between stock returns and inflation. The result show the relationship between real stock returns and inflation appeared to be inconsistent with the predictions of the Fisher hypothesis and common sense that common stocks should be a hedge against inflation but was in line with the post-war experience of the U.
Malaysia was a country that exhibits a positive relation between stock returns and inflation. Second, the identification and decomposition analyses show that the interaction of real and monetary disturbances appears to explain at least nine countries observed stock return and inflation relation.
In these countries, the real output disturbances drive a negative between stock return and inflation relation, while monetary disturbances yield a positive in stock return and inflation relation. Third, Indonesia and Malaysia turn out not to follow the above-mentioned pattern of real and monetary disturbances. In Malaysia, both real and monetary components yield a positive relation between stock returns and inflation.
In Indonesia, both real and monetary components yield a negative relation between stock returns and inflation. Kim and In investigated the Fisher hypothesis and its examination of the relationship between stock returns and inflation by using the wavelet analysis and hence examines nominal and real stock returns and inflation over the different time scales. They also investigate the variances, covariance of nominal and real returns and inflation.
The Effect of Inflation on Stock Prices
Correlations and cross-correlations between nominal and real returns and inflation were calculated for the different time scales. On the other hand, the study also examines the long-run relationship between stock returns and inflation not only in nominal but also in real terms.
The results of the regression analysis in the wavelet domain and the wavelet correlation show that the relationship was positive at the short horizon. Another results indicated that in all regression analyses, real returns have a significant negative relationship with inflation except for the shortest time scale d1 and the longest smooth scale s7 in wavelet analysis.
Lee reevaluate whether the stock return and the inflation relation indeed due to inflation illusion by reexamining the hypothesis using longer sample period of the US and international data. The inflation illusion hypothesis explained the post-war relation well; it was not compatible with some features of the pre-war relation.
A major problem is that while this hypothesis anticipates underpricing of stock prices with high inflation. Thus, the study observed the overpricing with high inflation in the pre-war period. This implies that although the mispricing component plays an important role in the stock market and inflation relation in both subsample periods. The result found the two types of stock return and inflation relations without imposing a particular permanent and temporary restriction on the two types of shocks.
The two regime hypothesis show positive and negative inflation shocks can be easily compatible with both pre- and post-war relations in the US. There were indeed two distinct forces in the economy in each period, and they drive the relation in opposite directions. The observed relations in the pre-war and post-war periods are consistent with the relative importance of these shocks.
The bivariate VAR identification found that there are two types of stock return and inflation relations in each developed countries. Researcher considered and the observed negative relations in these countries were again consistent with the relative importance of the two types of inflation shocks. Hondroyiannis and Papapetrou studied the dynamic relationship between real stock returns and expected and unexpected inflation utilizing a Markov Switching vector autoregressive model MS-VAR.
A Markov regime-switching model MS was employed to capture the structural breaks during the estimation period once the two parts of inflation are determined. The Markov regime-switching model has the advantage that it was able to capture the dependence structure of the series both in terms of the mean and the variance.
The results suggest that actual inflation does not significantly influence real stock market returns. Inflation was then decomposed into two components, one due to supply shocks permanent inflation and one due to demand shocks temporary inflation.
The variables of this study are stand from interest rate U. All the data are transformed into logarithms. The variables were initially tested for unit root using the Augmented Dickey Fuller test. This is followed by the Cointegration test to determine the number of cointegrating vectors.
After determining the cointegrating vectors that shows the long run relationship between the variables, the short run relationship was determine using the Vector Error Correction Modeling. The Cointegration Test in the table shows the variables are co-integrated.
The Trace statistic value is lower than critical value at 5 percent significance level, indicating 1 cointegrating equations at 5 percent significance level. This means that there is a long run relationship between the two equation models above.
The Trace statistic value is greater than critical value at 5 percent significance level, indicating 1 cointegrating equations at 5 percent significance level. The Trace statistic value is greater than critical value at 5 percent significance level, indicating 3 cointegrating equations at 5 percent significance level.
This indicates that variables expected inflation, exchange rate, interest rate and GDP are significant in explaining the changes in stock market in the long run. The sign of negative explained that there are found in expected inflation, exchange rate and interest rate to have negative impact on the stock market while GDP has positive impact on the stock market. Based on this result, the expected inflation, exchange rate and interest rate are claimed to be substitute to GDP in influencing the stock market.
In addition, from the Coefficient value, it can be claimed that exchange rate has bigger impact than the others variables in influencing the stock market. For the table 4. Same as table 4. This indicates that variables exchange rate, interest rate and GDP are significant in explaining the changes in stock market in the long run. The sign of negative in GDP explained negative impact on the stock market while Expected inflation, exchange rate and interest rate have positive impact on the stock market.
Based on this result, the GDP are claimed to be substitute to Expected inflation, exchange rate and interest rate in influencing the stock market. From the Coefficient value,it can be claimed that GDP In contrast, Table 4.
This indicates that variables unexpected inflation rate, exchange rate, interest rate and GDP are significant in explaining the changes in stock market in the long run. The GDP explained negative impact on the stock market while unexpected inflation, exchange rate and interest rate have positive impact on the stock market. Based on this result which same as result in table 4. The sign of negative explained that there are found in expected inflation and exchange rate to have negative impact on the stock market while interest rate and GDP have positive impact on the stock market.
Based on this result, the expected inflation and exchange rate are claimed to be substitute to Interest rate and GDP in influencing the stock market. The coefficient value claimed that exchange rate has bigger impact than the others variables in influencing the stock market. The estimated t-value for Exchange rate In contrast, Unexpected inflation This indicates that variables exchange rate, interest rate and GDP are significant, while unexpected inflation is insignificant explaining the changes in stock market in the long run.
There are found in exchange rate and interest rate to have negative impact on the stock market while unexpected inflation and GDP have positive impact on the stock market.
Based on this result, the exchange rate and interest rate are claimed to be substitute to unexpected inflation and GDP in influencing the stock market. Lastly, the coefficient value shows that exchange rate has bigger impact than the others variables in influencing the stock market.
The error correction term 1 shows that the estimated t value of —0. The F-statistic is 2. All variables in lag 1 and lag 2 for t-values, stock market 3. The error correction term 1 found in Table 4. All variables in lag 1 and lag 2 for t-values, stock market 2. Because the Unrestricted Cointegration Test indicated 3 cointegrating equations, there are 3 error correction term.
All variables in lag 1 and lag 2 for t-values, stock market Same as the Table 4.