Causal relationships between stock returns and inflation

Abstract

This article studies correlations and dynamic interactions between real stock returns and inflation in the UK for 1830–2000. The BLS test suggests that an endogenous break point exists in 1970, and therefore the pre- and post-break periods are required to be analysed separately. According to the empirical results, for the post-break period, unpredictable stock returns present little correlation to unpredictable inflation, and an increase in stock returns has an insignificant effect on inflation. Impulse response analyses also demonstrate that a positive shock to inflation does not have a negative impact on stock returns. These results are in contrast to the well-known empirical results for the pre-break period.

Notes

¹ The LR test results suggest that Model 3 dominates both Model 2 and the model in which the dummy variable is included in all variables Γ, ω, A and B. Therefore, Model 3 is chosen.

² These results do not significantly change, even when real GDP and bond price indices are simultaneously considered.