THE EFFECT OF INFLATION ON EQUITY RETURNS: THEORY AND EMPIRICAL TESTS FOR JAPANESE MARKETS.

Abstract

This study develops empirical models for comprehensive inflation effects on stock returns in the Japanese economic and financial framework. Basically these models deal with the two kinds of wealth effects and inflation risk premia. The wealth transfers are related to a tax system and other institutional constraints while the wealth-size effect is based on the more fundamental stock price determinant of the flows of earnings. The inflation risk premia are the additionally required part of returns due to relative uncertainties in common stock investment under unstable inflation. Based on the stock valuation theory and on the efficiency of stock markets, it is found that the net effect of wealth transfers appears in ex post stock returns if expected inflation shifts from one level to another. However, the effect of the inflation-caused wealth transfers will not appear in stock returns even in varying inflation if positive and negative wealth transfers are perfectly offset. The test result supports this offset. As the result of testing inflation risk premia, the stock market tends to compensate the premia of unstable inflation for investors. Finally the wealth-size effect relates anticipated real activity to inflation in monetary sector behaviors as well as anticipated real activity to stock returns in real sector behaviors. The intermediate variable to transmit inflation to stock returns is real activity. In this context, inflation is just the proxy for real activity which essentially determines firm values. Empirically the wealth-size effect is supported with the inverse relationship between inflation and real stock returns. For Japanese economy, however, the wealth-size effect is not explained by the standard theory of capital investment. Real activity is correlated to (profit) returns on existing capital but not related to corporate capital investment. Capital investment is independent of other real sector variables as well as inflation. The result is attributed to governmental policy and controls for corporate investment. Thus, the obtained relationship between stock returns and inflation includes less practical implication in investment behaviors.