Stock returns and inflation: a macro analysis

A negative relationship between stock returns and (expected) inflation is frequently observed in empirical work and is considered a puzzle since it is expected that stocks are a good hedge against inflation, so that their real rate of return (actual or expected) ought to be unaffected by changes in inflation. Various attempts have been made to resolve this puzzle empirically but have tended to use single equations of a partial equilibrium nature which have been ad hoc to a greater or lesser extent. This paper examines the puzzle in the framework of a small empirical macroeconomic model. The negative sign survives the extension to the full model and the source of the puzzle is found in the macroeconomic interactions: a rise in the expected inflation rate raises equilibrium real output which has a negative impact on stock returns.