Stock Returns and Inflation Innovations with State-Dependent Inflation Non-Neutrality

We show that the concurrent relation between quarterly stock returns and inflation innovations is appreciable and robustly significant only over weaker economic times, strikingly positive over 1997:Q4-2017:Q4 but negative over 1981:Q3-1997:Q3. Otherwise, the stock-inflation relation is relatively much smaller and near zero to marginally negative over both our pre-1997 and post-1997 periods. We suggest two complementary channels for understanding our main findings. First, we find consistent state-dependent patterns in how inflation innovations are related to expected economic growth and/or the equity risk premium, suggestive of a ‘state-dependent inflation non-neutrality’ channel. Second, when controlling for more fundamental stock-valuation determinants, the partial stock-inflation relation is diminished modestly but remains important over weaker economic times. Along with other analysis, this suggests a ‘signaling intensity of inflation’ channel where inflation signals are more relevant for identifying the economic state when uncertainty is elevated. JEL Classification: G12

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