Does the stock market react to unexpected inflation differently across the business cycle?

Chao Wei

Applied Financial Economics, 2009, vol. 19, issue 24, 1947-1959

Abstract: I find that nominal equity returns respond to unexpected inflation more negatively during contractions than expansions. In particular, returns on firms with lower book-to-market ratio, or of medium size, demonstrate strong asymmetric correlations with unexpected inflation across the business cycle. The cross-sectional correlations of returns on book-to-market and size portfolios with unexpected inflation mostly reflect the heterogeneous factor loadings of these portfolios on one of the Fama-French factors, namely, the excess market return. By examining the cyclical responses to unexpected inflation of the three primitive forces which determine stock prices: the discount rate, the expected growth rate of real activity and the equity risk premium, I find that changes in expected real activity and the equity premium, signalled by unexpected inflation, are important in explaining the asymmetric responses of the stock market to unexpected inflation across the business cycle.

Date: 2009
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DOI: 10.1080/09603100903282622

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