Stock Returns, Inflation, and the Business Cycle

This study examines the effect of inflation on stock returns in the context of the policy reaction function theory. This theory contends that the nature and extent of the governmentÕs policy reaction to inflation will depend upon the current level of economic activity. A contractionary policy, which will depress stock returns, is more likely when the economy is at a business cycle peak than at a trough. Therefore, the effect of inflation on stock returns varies with the stage of the business cycle. In order to test this theory, monthly consumer price indices, capacity utilization indices, and stock returns were examined. The results of using the returns of both a market index and a sample of individual companies between 1962 and 1988 support the theory.