Stock returns, velocity dynamics and inflation volatility

ABSTRACT

Our model relates the variability of stock returns to the variability of consumption velocity and shows that real stock returns tend to co-vary negatively with expected inflation in a period (or regime) of low and stable inflation and to co-vary positively with expected inflation in a period (or regime) of high and volatile inflation. Long-run real stock returns are shown to be positively related to expected inflation. Our empirical results for 20 countries provide consistent support for our propositions, indicating that the standard deviation of the annual inflation rate roughly equal to 10% is the dividing line between negative and positive return-inflation relations.

KEYWORDS:

• Real stock returns
• velocity
• volatile inflation
• stable inflation
• CRRA

JEL CLASSIFICATIONS:

• E44
• G12

Acknowledgements

We would also like to thank H. Youn Kim, Keun-Yeong Lee, Yun Dokko, Tong H. Lee, Charles Register, Jon Ford, Seung H. Jwa, Joo H. Nam, Jang Ok Cho, Insill Yi, and seminar participants at the Bank of Korea, Texas A&M University, Florida Atlantic University, Yonsei University, Ajou University, Sogang University, and the Korea Economic Research Institute (KERI) for their useful comments. Special thanks go to three anonymous referees and the Associate Editor of The European Journal of Finance for their valuable comments and helpful suggestions that improved the paper significantly. Any remaining errors are the responsibility of the authors.

Disclosure statement

No potential conflict of interest was reported by the authors.

ORCID

Sang Bong Kim http://orcid.org/0000-0002-3646-4208

Notes

1 Fama and Schwert (1977) show that U.S. government bonds were a complete hedge against expected inflation, and private residential real estate was a complete hedge against both expected and unexpected inflation.

2 Fama (1981) examined relations between real stock returns and both expected and unexpected inflation, but the evidence on the relations between real stock returns and unexpected inflation is less consistent. Stulz (1986) investigated the relationship between real stock returns and expected inflation, changes in expected inflation, and unexpected inflation and found that the strength of the relationship was weaker when the increase in expected inflation was caused by an increase in money growth rather than by a worsening of the investment opportunity set. Kaul (1987) found negative relations between real stock returns and expected, unexpected, and changes in expected inflation under counter-cyclical monetary policy regimes and positive relations under pro-cyclical monetary policy regimes. Lee (1992) observed that nominal stock returns and changes in expected inflation are weakly negatively correlated, and real stock returns and ex post inflation are mildly negatively correlated.

3 Fama (1981) implicitly recognizes the importance of the role of velocity in explaining the relation between real stock returns and expected inflation. He notes that the spurious negative relations between inflation and expected real returns are induced by a somewhat unexpected characteristic of the money supply process during the post-1953 period, in particular, the fact that most of the variation in real money demanded in response to variation in real activity has been accommodated through offsetting variation in inflation rather than through nominal money growth. The money supply process, real money demanded, real activity, and inflation are all essential elements of velocity. Bakshi and Chen (1996) also note that nominal stock prices are negatively related to the contemporaneous velocity of money, while real stock prices are positively correlated with the velocity of money three-quarters ahead (Friedman 1988).

4 Boudoukh and Richardson have obtained similar results using ex ante inflation.

5 If α approaches one, the CRRA utility function becomes for analytical tractability, the preferences of the agent are assumed to be represented by the logarithmic utility function.

6 See, for example, Fountas, Karanasos, and Kim (2006). For the empirical evidence among developing economies, see Gillman and Nakov (2004) and Gillman and Harris (2008).

7 Akerlof, Dickens, and Perry (2000) break down the sample from 1954 through 1999 into two sub-samples: those quarters when the five-year average of inflation was below 3% and those when it was above 4%. The samples have mean inflation rates of 2.0% and 6.3%, respectively. They have found the coefficient on inflationary expectations in the Phillips curve to be consistently and substantially larger in periods of high inflation than in periods of low inflation. Thus, they have concluded that the incorporation of price expectations varies with the inflation rate.

8 See Nelson (1976) and Gultekin (1983).

Additional information

Funding

The first author is thankful to the Bank of Korea for its financial support for the earlier version of the paper.

Notes on contributors

Ky-Hyang Yuhn

Ky-Hyang Yuhn obtained his Ph.D. in Economics, Northern Illinois University (1985); 1988–1991: ABD in Finance, The Wharton School of the University of Pennsylvania.Experience: 1993–Present: Associate Professor, Florida Atlantic University; 1992–1993: Associate Professor, University of Minnesota, Morris; 1984–1992: Assistant Professor, University of Minnesota, Morris; 1989–1991: Instructor, The Wharton School of the University of Pennsylvania.

Sang Bong Kim

Sang Bong Kim earned his MA in Economics from Sogang University in Korea and his Ph.D. from Texas A&M University. He has taught at Dankook University and is currently a Professor of Economics at Hansung University.

James Ross McCown

James Ross McCown earned his MBA from the University of Texas and his Ph.D. from Ohio State University. He has taught at Florida Atlantic University, Oklahoma City University, and Oklahoma State University. He is now in the Division of Finance at the University of Oklahoma.