Stock prices, inflation and inflation uncertainty in the U.S.: testing the long-run relationship considering Dow Jones sector indexes

ABSTRACT

We test for the long-run relationship between stock prices, inflation and its uncertainty for different U.S. sector stock indexes, over the period 2002M7–2015M10. For this purpose we use a cointegration analysis with one structural break to capture the crisis effect, and we assess the inflation uncertainty based on a time-varying unobserved component model. In line with recent empirical studies we discover that in the long run, the inflation and its uncertainty negatively impact the stock prices, opposed to the well-known Fisher effect. In addition we show that for several sector stock indexes the negative effect of inflation and its uncertainty vanishes after the crisis outburst. However, in the short run the results provide evidence in favour of a negative impact of uncertainty, while the inflation has no significant influence on stock prices, except for the consumption indexes. The consideration of business cycle effects confirms our findings, which proves that the results are robust, both for long- and short-run relationships.

KEYWORDS:

• stock prices
• inflation uncertainty
• cointegration with structural breaks
• unobserved component model
• U.S.

JEL CLASSIFICATION:

• C22: E31
• G15

Acknowledgments

This work was supported by a grant of the Romanian National Authority for Scientific Research and Innovation, CNCS – UEFISCDI, project number PN-II-RU-TE-2014-4-1760.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ The link between inflation and its uncertainty on the one hand, and between the inflation uncertainty and output on the other hand, became famous with the Friedman’s Nobel lecture (Friedman 1977). The first hypothesis of Friedman, showing the role of inflation uncertainty in explaining the level of inflation, was formalized by Ball (1992) (we call this Friedman–Ball hypothesis). Afterwards, several competing hypothesis where advanced and become famous, showing the positive impact of inflation on its uncertainty (Cukierman and Meltzer 1986), or on contrary, a negative relationship where the inflation leads uncertainty (Pourgerami and Maskus 1987), or where the inflation is leaded by its uncertainty (Holland 1995).

² Campbell (1991) explains this reasoning by the fact that, if the stock returns are expected to rise in the distant future and if the path of dividends is fixed, then the stock price must drop in present to allow a rise in the future.

³ The unbounded model of Stock and Watson (2007) might be considered inconsistent if the monetary authority decides to intervene if inflation moves outside of a desirable range, that is, if an inflation targeting regime is in place. According to Bullard (2012) and Thornton (2012), although the Federal Reserve is not formally inflation targeting, it is believed to be an implicit inflation targeter. In this case, inflation expectations are not allowed to evolve in an unbounded fashion. Chan et al.’s (2013) approach for assessing inflation uncertainty uses a time-varying unobserved component model, which allows for the trend inflation to be bounded in specific limits. However, in this case the inflation uncertainty is by definition an I(0) variable. Therefore, although this approach is theoretically appealing, it does not allow us to test the long-run relationship between stock prices, inflation and its uncertainty, and to use the Gregory–Hansen cointegration test.

Additional information

Funding

This work was supported by the UEFISCDI Romania [PN-II-RU-TE-2014-4-1760].