Abstract:

We re-assess the relation between inflation uncertainty and the real stock return for the US over a period of four decades. The reported results so far have been inconclusive to support the variability hypothesis. This hypothesis contends that high inflation leads to high inflation uncertainty, and high inflation uncertainty dampens economic activity resulting in lower stock return. The main difficulty is to estimate the unobserved inflation uncertainty. Most researchers employ GARCH type variance specification for inflation. We propose a structural model for inflation with time varying parameters that allows us to decompose inflation uncertainty in two components: structural and impulse. With the help of these components of inflation uncertainty we conclusively prove the variability hypothesis for the entire sample period.