In the 1930s Irving Fisher hypothesized that the interest rate should fully anticipate movements in expected inflation in order to yield the equilibrium real interest rates. The expected real interest rate is determined by real factors such as the productivity of capital and preference of consumers, and is independent of the expected inflation rate. In principle, the Fisher hypothesis could be extended to any asset, such as real estate, common stock, and other risky securities (Juttner 1994).
The empirical relationship between inflation and the stock marketwas first investigated by Jaffe and Mandelker (1976) in the US. This study found a negative relationship between the returns in the stock market and inflation. However, they found a positive relationship between the two variables over a much longer period. For the period of 1953-1971, the returns on stocks had been negatively related to the anticipated inflation. However, for the period between 1875 and 1970, the yearly returns on stocks were independent of past rates of inflation. Jaffe and Mandelker‟s (1976) result suggests a negative relationship, in the short run, between unanticipated inflation and the returns to common stock, a result that is consistent with previous empirical work. However, the Fisher Hypothesis (positive relationship) holds in the long run.
Following this pioneering study by Jaffe and Mandelker (1976), Fama and Schwert (1977) investigated the inflation effect on asset returns for a number of assets using the US data. They documented a negative relationship between stock returns and both expected and unexpected inflation. Fama and Schwert (1977) concluded that common stocks seem to perform poorly as a hedge against both expected and unexpected inflation. They also examined the qualities of various assets as hedges against the expected and unexpected components of the inflation rate during the 1953-71 periods. They found that US government bonds and bills were a complete hedge against expected inflation, and private residential real estate was a complete hedge against both expected and unexpected inflation. Labour income showed little short-term relationship with either expected or unexpected inflation. The most anomalous result is that common stock returns were negatively related to the expected component of the inflation rate, and probably also to the unexpected component. While the negative relationship of the stock return with expected inflation does not account for a large portion of the variation in stock returns, and although it does not seem to imply profitable trading rules, the existence of the relationship is nonetheless anomalous.
Saunders and Tress (1981) discussed the effects of inflation in a rational investor valuation framework in Australia. They argued that the empirical tests suggest that the nominal stock returns and inflation are related in a significantly negative manner. This implies that stocks were extremely poor hedges against inflation for investors over the period of 1965 and 1979. Saunders and Tress (1981) offered two explanations for the negative relationship between inflation and stock return. Firstly, investors act rationally relying on historic cost accounting. Secondly, investors become aware of the effect of inflation with a considerable time lag. These points would explain the initial negative effects of inflation on returns and the following positive adjustments that appear after about two quarters. This lagged explanation, however, casts doubts on the efficiency of the Australian stock market. According to Saunders and Tress (1981) the conventional wisdom held by most investment analysts was that shares provided investors with a relatively safe hedge against inflation. A theoretical justification for this belief could be found in an extension of the so-called Fisher effect, and in a number of other models of rational investor behaviour.
Gultekin (1983) investigated the relationship between common stock returns and inflation in twenty-six countries for the period between 1947 and 1979 using time series and cross-sectional data. Time series results did not support the Fisher hypothesis, and cross- sectional data studies found that countries with high inflation are associated with high nominal stock returns. He argued that international tests of the Fisher Hypothesis and its explanation have also not reached consensus. Gultekin‟s (1983) results do not support the Fisher Hypothesis, which states that real rates of return on common stocks and expected inflation rates are independent and that nominal stock returns vary in one-to-one correspondence with expected inflation. There is a consistent lack of positive relation between stock returns and inflation in most of the 26 countries.
Boudoukh and Richardson (1993), using almost two centuries of US annual data on inflation, stock returns, and interest rate over 1802-1990, examined the relationship between stock return and inflation in the long-term. They found that the long-term stock return relates positively to a change in inflation. Their paper provides strong support for a positive relationship between nominal stock returns and inflation in the long run. However, the coefficient of the relationship is less than 1. Boudoukh and Richardson. (1993) further claimed that Fisher‟s theory does not appropriately take into account real world complications and the Fisher effect reappears in cross-section data, together with the use of the inflation expectations.
Groenewold et al. (1997) examined the relationship between stock market return and inflation using Australian data between 1960 and 1991in 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. According to Groenewold et al. (1997), one way of looking at the relationship is to say that the Fisher Hypothesis should apply to returns on all assets (not only interest rates). Therefore, the expected nominal return on stocks should be equal to the expected (required) real return on stocks plus expected inflation. Inflation should not affect real stock prices; nominal stock prices are indexed to the general price level. Ex post, it is expected that stocks will prove to be an effective hedge against inflation since they are a claim on real assets, the productivity of which should be independent of the inflation rate. In its ex ante form, it is clearly an application of the Fisher Hypothesis to stocks.
A study by Kim and Shukla (2006) examined the relation between international security returns and expected inflation using data between 1988 and 2002. They hypothesized that the inflation sensitivity of a security is negatively related to its stock characteristic (sensitivity to
a stock factor) and positively related to its bond characteristic (sensitivity to a bond factor). This paper shows the inflation sensitivity of a security is positively related to its sensitivity to the world bond index and negatively to the world stock index. The results of the tests with the international stock returns of 23 countries and 83 international equity mutual funds support the hypothesis. Therefore, the sensitivities of securities‟ returns to bond and stock market returns may be used to assess their sensitivities to inflation.
A recent study by Hoesli et al. (2008) investigated the hedging characteristics of UK and US investment between 1977 and 2003 using the error correction approach. They found that the inflation hedging properties of stocks have produced anomalous results, with stocks often appearing to offer a perverse hedge. The authors attributed the anomalous result to the impact of real and monetary shocks to the economy, which influence both inflation and asset returns. This paper also investigated the relationship between commercial real estate returns and inflation for US and UK markets. It demonstrated that, in the long run, in both the UK and the US, asset returns are positively linked to anticipated inflation but not to inflation shocks.
Hasan (2008) examined the Fisher hypothesis about stock returns and inflation in the UK using the data between 1968 and 2003. This study used cointegration and a vector error correction model. Consistent with the Fisherian hypothesis, the regression results suggest a positive and statistically significant relationship between stock return and inflation. The results based on the unit root and cointegration tests indicate a long-run reliable relationship between price levels, share prices, and interest rates, which could be interpreted as the long- run determinants of stock returns. Results from the vector error correction model also suggest a bidirectional relationship between stock returns and inflation.
The Fisher effect postulates that the expected nominal interest rate is the sum of the expected real interest rate and the expected inflation rate. Empirical evidence indicates that
stock returns are negatively related to expected inflation. Many studies find negative relationships between stock returns and inflation for most of the industrialized countries. The empirical literature on the Fisher Hypothesis has been rich and the findings of many studies have been quite similar. The Fisher effect in stock prices is rejected in the short run. However, the Fisher Effect Hypothesis found support in a longer time frame. The long run relationship between inflation and stock return is positive as the Fisher Hypothesis suggests but the coefficient of relationship is not 1:1 in the long run.