The effects of inflation and inflation uncertainty on stock indices: evidence from 8 countries

Abstract

In this paper, I investigate the ambivalent role of inflation and inflation uncertainty on stock indices. Most specifically, I examine the effects of inflation and inflation uncertainty on stock indices, using evidence from eight industrialized countries (Canada, France, Germany, Israel, Spain, the United Kingdom, the United States of America and Greece). To do so I firstly extract a measure of inflation uncertainty using exponential generalized autoregressive conditional heteroscedasticity models (E-GARCH models). Then I examine the influence of inflation and inflation uncertainty using VAR model analysis and test for the existence of Granger-causality. Finally, I use impulse responses to examine how a sudden change in inflation and inflation uncertainty affects stock indices. The results indicate that a shock in inflation negatively affects stock returns in 6 out of 8 countries (Canada, Germany, Israel, Spain, UK, USA) and a shock in inflation uncertainty affects only 4 out of 8 eight countries (some positively and others negatively). Furthermore, I find evidence that stock returns strongly affect the inflation.