Inflation Targeting Regime and the Relationship between Stock Returns and Inflation: New Evidence using the VAR Approach

Abstract

Many industrialized and emerging countries have adopted inflation targeting monetary policy since 1990 to combat persistently high inflation rate. Based on the assertion that a unique and interesting relationship between stock returns and inflation rate exists for inflation targeting countries, this study investigates dynamic relationship between stock returns and inflation rate for a selected group of countries that implemented inflation targeting policy in the 1990s – namely, Brazil, Canada, Chile, Israel, South Korea, Sweden and the United Kingdom. It is found that changes in inflation rate precede or Granger cause changes in real stock returns for most of these countries. This relationship implies that forward-looking investors in inflation targeting countries are inclined to trade stocks based on anticipated future economic events resulting from a change in current inflation rate.