Irrelevance of Inflation and Inflation Uncertainty to Stock Returns

The purpose of this chapter is to reexamine the empirical evidence on the relation between inflation,
and inflation uncertainty, with stock returns, using monthly data for a duration of sixty-three years to
seventy years. Two series for inflation are considered: consumer CPI inflation and core inflation (i.e.,
without volatile food and energy prices). Two proxies for inflation uncertainty are used: Absolute
inflation and the square of inflation. Over the long run, prices and stocks are co-integrated with a
positive but more than proportionate impact. However, co-integration dissipates when fundamental
variables are included to the regressions. Over the short run, inflation and inflation uncertainty do not
explain well stock returns, whether separately or jointly. This is also especially true when fundamental
variables are included in the regressions. Two fundamental variables are selected from the Gordon
constant growth dividend model: The change in the cost of equity and the growth rate of earnings.
The first variable is roughly measured by the change in the Moody’s Baa corporate bond yield, while
the second one is taken to be the rate of change of industrial production. The latter variable stands
additionally for the evolution of the business cycle. Stability of the models is supported by testing for
calendar breakpoints.