inflation and asset returns

*Corresponding author.

European Economic Review 43 (1999) 737—754

Theories of Money, Credit and Aggregate Economic Activity

Inflation and asset returns

Michelle Barnes!, John H. Boyd", Bruce D. Smith#,$,*! Department of Economics, University of Adelaide, Adelaide, S.A. 5005, Australia

" Department of Finance, Carlson School of Management, University of Minnesota, 321,19th Avenue South, Minneapolis, MN 55455, USA

# Department of Economics, University of Texas at Austin, Austin, TX 78712, USA$ Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland, OH 44101, USA

Abstract

Sustained inflation is detrimental to long-run growth and the financial system. A re-cent theoretical literature suggests that high inflation implies low real returns on assets.These low returns exacerbate informational frictions, interfering with the functioning offinancial markets and the allocation of investment. We investigate the plausibility of aninverse relationship between inflation and real returns. Inflation and nominal equityreturns are negatively correlated or uncorrelated for all low-to-moderate inflation econo-mies examined. Safe nominal rates of return and inflation are only weakly positivelycorrelated. However, for high inflation economies inflation and nominal returns arestrongly positively correlated. ( 1999 Elsevier Science B.V. All rights reserved.

JEL classification: E5; E6; G2

Keywords: Inflation; Asset returns

1. Introduction

It is now well-established that sustained high rates of inflation have a detri-mental effect on an economy’s long-run level of real activity. In addition,

0014-2921/99/$ — see front matter ( 1999 Elsevier Science B.V. All rights reserved.PII: S 0 0 1 4 - 2 9 2 1 ( 9 8 ) 0 0 0 9 0 - 7

1Barro (1995) and Bullard and Keating (1995) establish the existence of a negative associationbetween long-run inflation and long-run growth. As Bullard and Keating’s results indicate, thisfinding is primarily driven by the experience of economies with relatively high average rates ofinflation. On the shorter-run consequences of high inflation see Bruno and Easterly (1998). Boydet al. (1997) find a strong negative correlation between inflation and financial depth: this correlationobtains both for bank lending activity and for equity markets. On the predictive power of financialmarket conditions for growth performance, see King and Levine (1993a,b), Levine and Zervos(1998), or Levine et al. (1998).

2See, for instance, Azariadis and Smith (1996), Boyd et al. (1996), Boyd and Smith (1998), Huybensand Smith (1997, 1998), or Schreft and Smith (1997, 1998).

episodes of high inflation lasting over many quarters are often associated with‘crises’ affecting the real economy. And, it appears to be the case that, over longperiods, inflation is highly detrimental to the development both of private creditmarkets and equity markets. This adverse impact is most pronounced foreconomies with low-to-moderate rates of inflation. And, over the long run, thisfact is likely to mean that inflation has strong consequences even for economieswhose inflation rates are moderate, as we know that financial market conditionsare strong predictors of future growth performance.1

But, why should sustained inflation have these strong effects? A recenttheoretical literature emphasizing the role of credit market conditions andinformational asymmetries in those markets strongly suggests that inflation caneasily have adverse consequences for financial markets and for long run capitalformation (both physical and human), and that inflation can enhance volatilityin the short run, or even in the long run.2 The common mechanism at work inthese models is that increases in inflation lead to lower real returns not just onmoney, but on all other assets too. Lower real returns have the effect ofexacerbating credit market frictions. As a result, higher inflation contracts thesupply of credit available to fund physical or human capital investment. Finan-cial markets become less deep, and long-run real activity is adversely affected.Moreover, these models often have ‘critical’ rates of inflation. Once the long-runinflation rate exceeds the critical rate, the models imply oscillatory dynamicsoutside of steady states. And, as Boyd and Smith (1998) or Schreft and Smith(1998) show, these oscillations need not dampen asymptotically.

As an empirical matter, what is the evidence that inflation has the conse-quences required for real returns in order for these mechanisms to operate? Thatquestion is the focus of this paper. Here we examine the empirical relationshipbetween inflation and a variety of asset returns for a sample of 25 countries forperiods as long as 1957.2 through 1996.3. For all of the countries in our sample,we have a time series of nominal returns on equity, as well as a time series on atleast one ‘safe’ asset. We also have, for almost all countries, a time series onprime lending rates and, obviously, we have time series on inflation for eachcountry. For each of our nominal return series, then, we investigate the relation-ship between nominal asset returns and inflation. Our findings are as follows.

738 M. Barnes et al. / European Economic Review 43 (1999) 737—754

3The point estimate is also negative for Japan. It is significant at the 20%, but not the 10% levelconfidence level.

With respect to nominal rates of return on equity, these are negatively corre-lated with inflation for 16 out of 25 countries. And for only 4 countries does thecorrelation between inflation and nominal equity returns exceed 0.1. Whennominal equity returns are regressed on contemporaneous rates of inflation, foronly four countries do we find coefficient estimates that are positive andsignificantly different from zero. And, point estimates suggest that the negativeimpact of inflation on ex post real rates of return will typically be quite large.

For ‘safe’ nominal rates of return, the simple correlation with inflation istypically much larger than one observes for equity returns. However, when weregress a ‘safe’ short-term rate on inflation, for only 11 countries do we findcoefficient estimates that are positive and significant. And, even for thesecountries all of the coefficients on inflation are fairly small (less than 0.5), and allof them are significantly less than one at conventional confidence levels. Similarresults are obtained for prime lending rates, where only 6 of 23 countries forwhich data are available have positive and significant inflation coefficients, andall of the estimated inflation coefficients are less than 0.2. Clearly these resultsare quite consistent with the notion that inflation has a strong negative impacton real rates of return on a large class of assets in most countries.

Moreover, when we consider nominal equity returns, the four countries thathave significant positive coefficients in the equity returns—inflation regressionare the four highest inflation countries in the sample. This observation isconsistent with the notion that incremental increases in inflation have smallereffects on real returns in countries whose initial inflation rates are high than theydo in countries whose initial rates of inflation are low. Or, in other words, inhigh inflation countries — and only in high inflation countries — do nominal ratesof return seem to adjust to provide some hedge against inflation. To ourknowledge, this disparity between high and low inflation countries has notpreviously been noted.

Finally, we make some attempt to consider ‘spillover’ effects of inflation.More specifically, we regress nominal equity returns country by country ondomestic rates of inflation as well as the U.S. inflation rate. For 9 out of 24countries, we find that the coefficient on U.S. inflation is negative and statis-tically significant (at the 90% confidence level). And indeed this is the case forthree countries that are major financial centers: Germany, Switzerland, and theU.K.3 Moreover, the effects of U.S. inflation on nominal equity returns in thesecountries is quite large: a one percentage point increase in the rate of U.S.inflation lowers nominal equity returns in Germany and the U.K. by more than2.5 percentage points. Thus changes in U.S. inflation potentially have strongconsequences for other nations.

M. Barnes et al. / European Economic Review 43 (1999) 737—754 739

4For example cash-in-advance or money-in-the-utility-function models.5Obviously we would prefer to include cash dividends in our calculations, if the necessary data

were available. However, based on U.S. data, it appears that the exclusion of dividends hasa minimal effect on quarterly equity index returns. It is also the case that the inclusion or exclusion ofdividends has not affected results of the kind reported here in examinations of inflation and nominalequity returns in the U.S. See Schwert (1981, p. 21).

In general we regard these findings as supportive of the notion that inflationcan impact negatively on a variety of real returns. Models that imply thatchanges in real returns can impact on credit or equity market conditionstherefore contain a very plausible channel by which inflation can affect financialmarket efficiency and the real economy.

As a final observation, we note that many monetary models4 imply thatinflation cannot affect steady-state real rates of return on assets. As we willargue, our results seem less supportive of this class of models.

The remainder of the paper proceeds as follows. Section 2 describes the dataemployed, and provides some rough summary statistics. Section 3 describes ourfindings when we regress various nominal rates of return on inflation. Section 4considers how U.S. inflation impacts on equity returns in other countries, whileSection 5 concludes.

2. Data description

We employ data on the following variables for up to 25 countries, dependingon the variable in question. A list of countries and sample dates appears inTable 1.

Nominal equity returns: Nominal equity returns are simply rates of change inan index of nominal share prices. Note, therefore, that our data on equityreturns exclude dividend payments.5 In any case, nominal rates of return onequity are expressed in percentages and we employ percentage rates of changeper quarter. Indices of share prices (IFS line 62) used to compute rates of changerefer to common shares of companies traded on national or foreign stockexchanges. These indices are base-weighted arithmetic averages with the marketvalue of outstanding shares as weights.

Money market interest rates: This is the nominal rate at which short-termborrowings are effected between financial institutions (IFS line 60b). Four of thecountries in our sample do not report data for such a rate (Chile, Israel, Peru,and the Philippines). For these countries we use a series on deposit rates: this isthe nominal interest rate offered by banks to resident customers for demand,time or savings deposits (IFS line 60l).

Prime lending rates: Here the name is totally descriptive (IFS line 60p).


Table 1Sample statistics

Country Mean inflation(quarterly)

Equity return:correlation withinflation

Money marketrate: correlationwith inflation

Prime lendingrate: correlationwith inflation

Australia 1.434 !0.139 0.176 !0.123Austria 0.981 0.047 0.181 —Canada 1.152 !0.085 0.593 0.625Chile 7.430 0.461 0.410 0.398Finland 1.575 !0.081 0.432 0.143France 1.485 !0.058 0.435 0.358Germany 0.800 !0.005 0.435 0.462India 1.907 0.083 0.046 0.072Israel 14.596 0.447 0.956 0.623Italy 1.894 0.02 0.527 0.771Japan 1.120 !0.135 0.434 0.428Korea 2.412 !0.162 0.708 0.627Luxembourg 0.964 !0.07 0.493 0.682Mexico 5.870 0.364 0.846 —Netherlands 1.029 !0.062 0.097 0.559New Zealand 1.794 0.069 0.725 0.155Norway 1.406 !0.083 0.150 0.388Peru 54.030 0.964 0.811 0.821Philippines 2.530 !0.047 0.375 0.369Portugal 2.669 !0.103 0.390 0.202Spain 2.213 !0.195 !0.054 0.331Sweden 1.484 !0.022 0.116 0.166Switzerland 0.860 !0.199 0.268 0.360U.K. 1.655 0.076 !0.032 0.316U.S. 1.109 !0.238 0.694 0.630

Note: All means are percentage rates of return per quarter.The sample period is 1957.2—1996.3 for all variables except: Australia (money market rate1969.3—1996.3; prime lending rate 1976.2—1993.1); Austria (money market rate 1967.1—1996.3);Canada (money market rate 1975.1—1996.3); Chile (equity return 1974.1—1996.3; deposit rate1977.1—1996.3, lending rate 1977.1—1996.3); Finland (money market rate and lending rate1978.1—1996.3); Germany (equity returns 1970.1—1996.3; lending rate 1977.3—1996.3); Israel (equityreturns 1980.3—1996.3; deposit rate 1983.4—1996.3; lending1979.1—1996.3); Italy (money market rate1971.1—1996.3; lending rate 1957.2—1982.3); Korea (equity returns 1978.1—1996.3; inflation1970.1—1996.3; money market rate 1976.4—1996.3; lending rate 1980.3—1996.3); Mexico (equityreturns 1984.1—1996.3; inflation 1958.1—1996.3; money market rate 1981.2—1996.1); Netherlands(money market rate 1960.1—1990.2; lending rate 1978.2—1996.3); New Zealand (equity returns1961.1—1996.1; money market rate 1983.1—1996.3; lending rate 1977.1—1996.3); Norway (moneymarket rate 1971.4—1996.3; lending rate 1979.1—1996.3); Peru (equity returns and inflation1989.1—1996.3; deposit rate 1988.1—1996.3; lending rate 1985.4—1996.3); Philippines (deposit rate andlending rate 1976.1—1996.3); Portugal (equity returns 1988.1—1996.3; money market rate1981.1—1985.4, 1991.3—1996; lending rate 1976.1—1996.3); Spain (money market rate 1974.1—1993.2;lending rate 1982.1—1996.3); Sweden (equity returns 1957.2—1995.4; money market rate1966.1—1996.3, lending rate 1970.1—1996.3); Switzerland (money market rate 1975.4—1996.3; lendingrate 1981.1—1996.3); U.K. (money market rate 1972.1—1996.3; lending rate 1966.3—1996.3); India(lending rate 1978.4—1996.3); Luxemburg (equity returns 1980.1—1996.3; money market rate1990.1—1996.3; lending rate (1980.1—1996.3).


Table 1a.

Meaninflation

Mean equityreturn

Inflationstandarddeviation

Returnsstandarddeviation

Cross sectional correlations: all countriesMean inflation 1Mean equity return 0.842 1Inflation standard deviation 0.987 0.896 1Returns standard deviation 0.737 0.892 0.796 1

Cross sectional correlations: high inflation countries omittedMean inflation 1Mean equity return 0.116 1Inflation standard deviation 0.876 0.108 1Returns standard deviation 0.487 0.546 0.535 1

Inflation: For the rate of inflation we use the quarterly rate of change in eachcountry’s CPI, expressed as a percentage. The CPI data are from IFS line 64.

Table 1 reports the mean value of inflation for every country, as well as thecorrelations of each variable with the rate of inflation in the relevant country.Observe that of the 25 countries in our sample, nominal equity returns arenegatively correlated with inflation for 16 of them. And 21 of 25 countries havecorrelations between inflation and nominal equity returns that are less than 0.1.Of the countries that display larger correlations between inflation and equityreturns (Chile, Israel, Mexico and Peru), all have quite high average rates ofinflation. In fact, all of these countries have average annual rates of inflation thatexceed the average annual rate of inflation for any other country in our sampleby at least 14 percentage points. In short, only for high inflation countries isthere even a moderately large positive correlation between nominal equityreturns and inflation. And among these countries, only one (Peru) displaysa correlation close to one.

As is apparent from Table 1, other nominal rates of return are much morestrongly correlated with inflation. Even so, for only 8 of 25 countries does thecorrelation between the money market rate and inflation exceed 0.5. For just8 of 23 countries does the correlation between inflation and the prime lendingrate exceed 0.5.

Table 1a shows simple correlations of sample means and sample standarddeviations across countries. For instance, the cross-sectional correlation be-tween mean inflation and the standard deviation of inflation is 0.99. Thecross-sectional correlation between the mean inflation rate and the mean nom-inal rate of return on equity is 0.84 (but see below). The correlation between themean rate of inflation and the standard deviation of equity returns is 0.74.Notice that these correlations are consistent with the notion that higher


6Results using OLS estimates are essentially the same when we consider the empirical relation-ship between nominal equity returns and inflation. Correcting for serial correlation is moreimportant when we consider rates of return on other assets.

7 In Spain and Switzerland the inflation coefficient is negative and significantly different from zeroat the 20% confidence level.

inflation leads not just to greater inflation variability, but to greater variabilityin other rates of return as well.

3. Asset returns and inflation

3.1. Nominal returns on equity

Table 2 reports, for each country in our sample, the point estimate andt-statistic when nominal equity returns are regressed on a constant, and thecontemporaneous rate of inflation. In each regression we have utilized theYule—Walker method to correct for first-order serial correlation.6 As is apparentfrom the table, only four countries (Chile, Israel, Mexico, and Peru) havecoefficients that are estimated to be positive and significantly different from zeroat the 5% significance level. Of these countries, one (Israel) has a coefficient oninflation that is significantly less than one, and one (Peru) has a coefficient oninflation that is significantly greater than one. Moreover, these countries havethe four highest mean rates of inflation in our sample. The country with the fifthhighest mean rate of inflation Portugal has an average rate of inflation less thanhalf that in any of these countries. Thus, for countries with low-to-moderaterates of inflation, Table 2 contains no evidence supporting the hypothesis thatinflation and nominal rates of return on equity are positively correlated. Indeed,for three low-to-moderate inflation countries there is evidence of a negativecorrelation: Australia, Japan, and the United States.7 While it remains an openissue as to why such an effect might be so strong, clearly this finding is consistentwith the view that inflation might have a negative effect on real returns.

It is also interesting to ask for how many countries does the coefficient oninflation differ significantly from one. The answer is ten, and in only one of thesedoes the relevant coefficient exceed one. Thus while for 60% of our samplea Fisher-like relation is not rejected, for 40% it is. These numbers are in sharpcontrast to what we find for the null hypothesis that nominal equity returns andinflation are not positively correlated. This hypothesis fails to be rejected for84% of the sample, and it is uniformly rejected for countries with low averagerates of inflation.

Since all the effects of a change in the rate of inflation might not be reflectedin equity returns within the quarter they occur, we also experimented with aregression of nominal equity returns on contemporaneous and lagged inflation.


Table 2Nominal equity returns and inflation*

Country Inflation coefficient(contemporaneousinflation only)

Coefficientscurrentinflation

Laggedinflation

F-statistic**

Australia !1.215 !1.506 0.806 2.607(!1.959) (!2.252) (1.201)

Austria 0.812 0.470 !0.604 0.850(1.259) (0.632) (!0.881)

Canada !0.693 !0.552 !0.154 0.408(!0.972) (!0.625) (!0.174)

Chile 0.854 0.443 0.359 3.669***(4.817) (2.004) (2.150)

Finland !0.008 !0.066 0.314 0.087(!0.011) (!0.087) (0.411)

France !0.203 0.668 !1.435 1.643(!0.299) (0.827) (!1.809)

Germany 0.373 0.814 !1.300 0.623(0.322) (0.661) (!1.070)

India 0.357 0.446 !0.370 1.777(1.048) (1.288) (!1.065)

Israel 0.524 0.344 0.467 27.260***(4.709) (3.451) (5.137)

Italy !0.114 !0.915 1.534 1.713(!0.161) (!1.101) (1.842)

Japan !0.829 !0.853 0.239 1.544(!1.689) (!1.724) (0.482)

Korea !0.599 !0.459 !0.344 0.467(!0.853) (!0.595) (!0.455)

Luxembourg !0.056 0.507 !1.307 0.235(!0.032) (0.267) (!0.685)

Mexico 1.150 0.892 0.382 2.362(2.126) (1.206) (0.517)

Netherlands !0.066 !0.081 !1.171 2.555(!0.125) (!0.155) (!2.255)

New Zealand 0.422 0.420 !0.059 0.448(0.941) (0.931) (!0.130)

Norway !1.058 !1.432 0.790 0.842(!1.087) (!1.293) (0.712)

Peru 1.174 1.284 !0.155 393.692***(21.808) (22.328) (!2.271)

Philippines 0.127 0.315 !1.151 2.004(0.224) (0.546) (!1.999)

Portugal !0.674 !0.810 0.511 0.125(!0.416) (!0.468) (0.302)

Spain !0.756 !0.619 !0.999 3.655***(!1.587) (!1.298) (!2.086)

Sweden !0.263 !1.288 2.067 1.626(!0.256) (!1.107) (1.781)


Table 2 (Continued)

Country Inflation coefficient(contemporaneousinflation only)

Coefficientscurrentinflation

Laggedinflation

F-statistic**

Switzerland !1.310 !1.240 !0.314 1.368(!1.598) (!1.442) (!0.364)

U.K. 0.373 0.371 !0.061 0.442(0.930) (0.921) (!0.153)

U.S. !1.907 !2.029 0.218 3.723**(!2.746) (!2.301) (0.247)

Note: t-statistics are in parentheses.* The Yule—Walker method was used to correct for first order serial correlation.** The null hypothesis is that the coefficients on both current and lagged inflation equal zero.*** Significant at 5% confidence level.

8Results for Peru should be interpreted with some caution given its turbulent political andmonetary conditions, and the relatively short period for which data are available.

The results are reported in Table 2. For two of the high inflation countries, Chileand Israel, both current and lagged inflation appear with coefficient estimatesthat are positive and significantly different from zero. For Mexico, on the otherhand, both coefficients are individually insignificant with current and laggedinflation as explanatory variables. And, F tests indicate that the two explanatorstaken together are jointly insignificant at the 5% confidence level. Finally, forPeru, lagged inflation enters significantly, but with a small negative coefficient.The sum of the coefficients on current and lagged inflation is virtually identicalto the coefficient on contemporaneous inflation when only a single explanatoryvariable is employed.8

For three lower inflation countries, the Netherlands, the Philippines, andSpain, lagged inflation enters with a negative and significant (at the 90% level)coefficient. In none of these countries is the coefficient on contemporaneousinflation significant at conventional confidence levels, nor was it significantwhen contemporaneous inflation was the only explanatory variable. In ourinterpretation this expands the set of countries where the data indicate a nega-tive relationship between inflation and nominal equity returns. (Recall that thisrelationship is negative for contemporaneous inflation in Australia, Japan, andthe United States.)

Finally, for only five countries do F tests indicate that the coefficients oncurrent and lagged inflation are jointly significant. These countries are Chile,Israel and Peru (high inflation), and Spain and the United States, where the datasuggest the existence of a strong inverse relationship between inflation andnominal equity returns.


9 Interestingly, average inflation and the standard deviation of nominal equity returns are quitepositively correlated even for low-to-moderate inflation countries. The cross-sectional correlationbetween these variables is 0.48, even when Chile, Israel, Mexico, and Peru are excluded from thesample.

To further investigate the hypotheses that the coefficient on inflation is eithernot significantly different from zero, or not significantly different from one, weproceeded as follows. We pooled our sample, and regressed the nominal rate ofreturn on equity in country i at t on a constant, country i’s inflation rate at t, anda complete set of time and country dummy variables. Also included was aninflation interaction term of the form H]INF, where INF is the currentinflation rate and H is a dummy variable taking on the value one for Chile,Mexico, Israel, and Peru (high inflation), and zero otherwise. With this specifica-tion we estimated an inflation coefficient of 0.104, which has a heteroskedastic-ity-consistent standard error of 0.161, and an inflation interaction coefficient of1.014 (with a heteroskedasticity-consistent standard error of 0.169). We alsoreestimated the same equation, but with all observations from Chile, Israel,Mexico, and Peru excluded, and obviously with no interaction term. Here weobtained an estimated coefficient on inflation of 0.12, with a heteroskedasticity-consistent standard error of 0.151. Both results strongly support what weconcluded from the country-by-country analysis: in low-to-moderate inflationcountries there is no evidence against the hypothesis that nominal equity returnsand inflation are uncorrelated. There is considerable evidence for these countriesagainst the more Fisherian hypothesis of a unit coefficient on inflation. Only forvery inflationary economies does the hypothesis of a unit coefficient seemstrongly supported in the data.

Of course one might be concerned that what we have done so far reflects‘short-run’ rather than ‘long-run’ relationships. To remedy this, we also com-puted the average nominal rate of return on equity for each country andregressed it on a constant plus the average rate of inflation in each country.When we did this with the four high inflation countries excluded, we recoveredan estimated inflation coefficient of 0.132, with a standard error of 0.258. Thusclearly ‘long-run’ relationships mirror the ‘shorter-run’ relationships we de-scribed previously. However, when the high inflation countries were included inthe sample the coefficient on inflation was estimated to be 1.314, with a standarderror of 0.047. Both findings, incidentally, are quite consistent with resultsobtained by Boyd et al. (1997). They found, using a cross-section of time-averaged data, that the partial correlation between inflation and nominal equityreturns was not significantly different from zero for countries with mean infla-tion rates below 15% per year. However, for countries with mean inflation ratesexceeding that level, nominal equity returns increase essentially one-for-onewith inflation. [See also Barnes (1998).] This is basically what we find as well.9


10A nice discussion of the univariate time series properties of short-term nominal interest rates inthe U.S. appears in Ait-Sahalia (1996). These issues do not arise for nominal rates of return on equity.

A second possible concern is that we have regressed nominal equity returnson the actual rate of inflation when the appropriate course of action would be toregress them on the expected rate of inflation. Under this view, the actual rate ofinflation is a noisy measure of the expected rate of inflation, and we havea classic ‘errors-in-variables-problem’ that biases our coefficient estimates to-wards zero. Of course this cannot explain the large number of negative coeffic-ient estimates that we obtain. But, under an auxiliary hypothesis, another‘check’ is also available.

Specifically, following Fama (1975), suppose we take the ex ante real rate ofreturn to be constant. Then we can regress the rate of inflation on the nominalrate of return on equity, and the errors-in-variables problem disappears. Undera Fisherian null hypothesis, the coefficient on the nominal equity return should beunity. However, when we performed these regressions, we again found that theestimated coefficient on the nominal equity return was negative for 15 out of 25countries. Indeed, it was negative and significantly different from zero (at the 10%confidence level) for five countries. As previously, the estimated coefficient waspositive and significant only for the four high inflation countries. And, this coeffic-ient was significantly less than one (at the 5% confidence level) for all 25 countries,including (obviously) those with a high average rate of inflation. Thus a confusionbetween actual and expected rates of inflation cannot explain our findings.

3.2. ‘Safe’ rates of return

We now briefly describe the results obtained by regressing a ‘safe’ nominalrate of return on a constant and inflation. For these tests we chose two short-terminterest rate series: a money market rate and a lending rate, both of which aredescribed above. For Chile, Israel, Peru, and the Philippines the money marketrate is not reported; here we substituted a deposit rate. These returns are reportedon an annualized basis. To make them comparable to quarterly rates of inflation,we transformed them according to (1#r

t)0.25!1, where r

tis the reported

annualized rate of interest. These quarterly rates of interest are then regressed ona constant and inflation. It is widely recognized that, for many economies,short-term nominal interest rate series display substantial persistence, althoughthey do not necessarily exhibit a unit root.10 Therefore we include two sets ofregressions. In the first we regress the level of the interest rate on the level of thecontemporaneous rate of inflation. Here we found that an ARMA (2, 1) processfor the error term provided ‘the best fit’. In the second we followed a commonpractice and regressed the rate of change in the nominal interest rate on the rateof change in inflation. The results are reported in Table 3.


Table 3Nominal interest rates and inflation

Country Coefficient of interest rateregressed on rate of inflation!

Coefficient of change in interestrate regressed on change in inflation

Money marketrate"

Prime lendingrate

Money marketrate"

Prime lendingrate

Australia 0.0285 !0.0065 0.0127 0.0143(4.28) (!0.73) (0.509) (0.876)

Austria !0.0122 — 0.0125 —(!0.89) (0.599)

Canada 0.395 0.306 0.0532 0.036(3.66) (1.32) (1.317) (1.704)

Chile 0.056 0.0614 0.0306 0.0152(2.65) (2.4) (1.110) (0.486)

Finland !0.0072 0.0087 0.0209 0.0224(!0.12) (0.74) (0.453) (1.676)

France !0.0021 0.0075 0.0186 0.0137(!0.11) (1.09) (0.987) (1.496)

Germany !0.0071 !0.008 0.0055 0.0239(!0.371) (!0.69) (0.212) (1.378)

India !0.0688 !0.0009 !0.0383 0.0068(!3.780) (!0.21) (!2.177) (1.114)

Israel 0.490 0.052 0.0846 0.052(8.54) (4.86) (1.400) (1.543)

Italy 0.1001 0.0854 0.1095 0.0469(4.100) (3.72) (4.637) (1.28)

Japan 0.0215 0.0017 0.0435 0.0082(1.650) (1.610) (3.027) (3.441)

Korea 0.0200 !0.0062 0.0333 !0.0004(0.93) (!0.860) (1.726) (!0.033)

Luxembourg 0.1932 0.0199 0.0858 0.0221(2.730) (1.690) (1.050) (1.991)

Mexico 0.2618 — 0.0519 —(6.00) (1.552)

Netherlands !0.0088 0.0002 !0.0193 0.0049(!0.380) (0.01) (!0.647) (0.129)

New Zealand 0.1346 0.031 0.1182 0.092(1.950) (0.91) (2.732) (2.429)

Norway !0.093 !0.0034 0.0122 0.0214(!1.80) (!0.42) (0.326) (1.816)

Peru 0.1405 0.1997 0.0374 0.0509(12.70) (4.17) (0.953) (1.115)

Philippines !0.0202 — 0.0548 0.056(!1.15) — (3.26) (3.464)

Portugal 0.0476 !0.0173 0.0706 0.0232(1.180) (!1.301) (3.142) (1.891)

Spain 0.011 0.0155 0.0551 0.0474(0.14) (0.49) (0.836) (1.01)


Table 3 (Continued)

Country Coefficient of interest rateregressed on rate of inflation!

Coefficient of change in interestrate regressed on change in inflation

Money marketrate"

Prime lendingrate

Money marketrate"

Prime lendingrate

Sweden !0.029 0.0267 !0.157 0.042(!0.052) (1.77) (!0.355) (2.392)

Switzerland !0.0377 !0.0121 0.0543 !0.0152(!1.120) (!1.62) (1.447) (!1.338)

U.K. 0.0002 !0.0029 0.0235 0.0153(0.010) (!0.24) (1.215) (1.206)

U.S. 0.1074 0.1375 0.0515 0.0829(3.340) (4.740) (1.849) (3.656)

t-statistics in parentheses.! The error term follows an ARMA (2, 1) process. Estimation utilized conditional least squares, SASArima procedure." For Chile, Israel, Peru, and the Philippines a deposit rate was substituted for the money marketrate.

Relative to equity returns, we find much more evidence that inflation hasa positive and significant effect on short-term nominal interest rates. In ourlevels regressions involving money market rates (deposit rates), 11 countrieshave positive and significant inflation coefficients. In the differenced specifica-tion, 7 inflation coefficients are positive and significant. In both cases onecountry, India, has inflation coefficients that are negative and significantlydifferent from zero. Similar results are obtained for the prime lending rate. Inlevel form 6 inflation coefficients (out of 23) are positive and significant; indifferenced form 10 coefficients are positive and significantly different from zero.

It is also true that in all of these cases the inflation coefficients tend to be quitesmall. In the levels specification every coefficient which is significantly differentfrom zero is also significantly less than one at conventional confidence levels. Thelargest inflation coefficient obtained was in the money market rate regression forIsrael, 0.49. This coefficient, however, is significantly less than one at the 99%confidence level. Thus again we find strong evidence against the hypothesis ofa unit coefficient. The evidence is entirely consistent with the notion that higherinflation is typically associated with lower ex post real rates of return.

4. Inflation ‘spillovers’

As a final endeavor, we take a preliminary stab at the following question: howis the rate of inflation in a large country (for us the U.S.) associated empirically


Table 4Regression of nominal equity returns on own inflation and US inflation

Country Estimate ¹-ratio

AustraliaINFN !1.317 !1.874USINFN 0.337 0.315

AustriaINFN 0.861 1.302USINFN !0.496 !0.422

CanadaINFN 0.011 0.010USINFN !1.107 !0.977

ChileINFN 0.885 4.931USINFN !2.739 !0.868

FinlandINFN 0.149 0.192USINFN !0.583 !0.473

FranceINFN !0.024 !0.031USINFN !0.514 !0.445

GermanyINFN 1.421 1.172USINFN !2.531 !2.443

IndiaINFN 0.273 0.779USINFN 1.206 1.004

IsraelINFN 0.554 5.491USINFN 10.599 2.815

ItalyINFN 0.198 0.247USINFN !1.369 !0.902

JapanINFN !0.602 !1.163USINFN !1.327 !1.366

KoreaINFN !0.498 !0.513USINFN !0.362 !0.158

LuxemburgINFN 1.153 0.636USINFN !3.930 !1.853

MexicoINFN 1.171 2.150USINFN 7.658 0.695

NetherlandsINFN 0.279 0.518USINFN !2.225 !2.602


Table 4 (Continued)

Country Estimate ¹-ratio

New ZealandINFN 0.589 1.255USINFN !1.412 !1.190

NorwayINFN !1.486 !1.365USINFN 1.241 0.867

PeruINFN 1.291 17.564USINFN !59.833 !2.171

PhilippinesINFN 0.383 0.659USINFN !4.483 !1.900

PortugalINFN 1.783 1.168USINFN !16.869 !3.789

SpainINFN !0.388 !0.769USINFN !2.240 !1.997

SwedenINFN !0.550 !0.461USINFN 0.740 0.474

SwitzerlandINFN !0.584 !0.684USINFN !2.213 !2.552

United KingdomINFN 0.910 2.040USINFN !2.862 !2.554

* Estimates are corrected for first-order autocorrelation using the Yule—Walker method.

with the nominal rate of return on equity in other countries? Or, in other words,might we expect that changes in the rate of inflation in the U.S. are typicallycorrelated with movements in nominal equity returns in other countries?

Table 4 reports estimated coefficients when nominal equity returns in eachcountry are regressed on a constant, the country’s own rate of inflation, and thecontemporaneous rate of inflation in the U.S. As is evident there, of the 24countries for which this makes sense, 9 of them have coefficients on U.S.inflation that are significantly different from zero at the 10% level and negative.One country (Israel) has a significant positive coefficient on U.S. inflation. Thusfor more than a third of our sample, higher inflation in the U.S. is typicallyassociated with lower nominal and real rates of return on equity. Moreover, thisis true for some countries that contain major financial centers: for instance


11For Japan it is also true that the coefficient on U.S. inflation is negative. This coefficient issignificant at the 20%, but not at the 10% level.

12See, for instance, Boudoukh and Richardson (1993); Breen et al. (1989); Erb et al. (1995); Nelson(1976), Fama and Schwert (1977), Gultekin (1983), and Barnes (1998).

Germany, Switzerland, and the U.K.11 And, the estimated coefficients on U.S.inflation are quite large. They suggest that, on average, a one percentage pointincrease in the U.S. inflation rate is associated with a decline of more than 2.5percentage points in nominal equity returns in Germany and the U.K. The pointestimate for Japan also suggests more than a one-for-one decline.

It bears emphasis that in this same set of regressions, the coefficient on owninflation is significantly different from zero at the 10% level for only sixcountries. Four of them are the familiar high inflation countries. Of these fourcountries, in only one (Peru) is the coefficient on U.S. inflation negative andsignificant. Thus of the 20 low-to-moderate inflation countries, 8 have a coeffic-ient on U.S. inflation that is negative and significant. Only two have a coefficienton own inflation that is significantly different from zero. This suggests that U.S.inflation has a stronger impact on nominal (and real) equity returns around theworld than does a country’s own rate of inflation. And, of course, the datasuggest that where U.S. inflation matters, higher U.S. inflation is generallyassociated with lower nominal and real rates of return on equity. And, if theselower real returns exacerbate financial market frictions and retard growth, this isa mechanism by which U.S. inflation can be transmitted to other countries.

5. Conclusions

Lucas (1980) has argued that one of the empirically best supported proposi-tions in economics is the following: when inflation rises (in the long-run),nominal rates of interest rise by the same amount. Our results suggest that thefollowing claim is at least equally well supported by the data: nominal rates ofinterest and rates of inflation are approximately uncorrelated, at least forcountries with low-to-moderate rates of inflation. Indeed, for several countrieswe find evidence of some negative relationships between inflation and nominalequity returns. Moreover, our conclusion is quite consistent with other evidencecompiled by a variety of other authors.12

Given the empirical support for the latter proposition, one cannot rule out asunreasonable classes of models where higher rates of inflation reduce real ratesof return very generally. In these models inflation will therefore necessarily havereal effects. And, in many models, the result of higher inflation will be increasing-ly severe financial market frictions, reductions in liquidity and credit extension,and reduced (physical and human) capital investment.


Finally we have found that not only is higher U.S. inflation associatedempirically with lower nominal (and real) equity returns in the U.S.: it isassociated with lower nominal (and real) equity returns in almost 40% of oursample. Indeed, U.S. inflation has a larger estimated partial correlation withnominal equity returns in many countries than own inflation does. And this istrue for countries with large and important financial centers like Germany,Switzerland, and the U.K. Thus it seems reasonable to conclude that U.S.inflation is, for the world as a whole, decidedly nonneutral.

Acknowledgements

We thank Jian Hu and Dona Ray for outstanding research assistance, NobuKiyotaki for his comments, and Ross Levine for his help at any number of pointsin this research project.

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