TAILIEUCHUNG - STOCK RETURNS AND INFLATION: THE IMPACT OF INFLATION TARGETING

I would like to extend my thanks to all those who contributed to this study. In addition to the research team, I would like to thank the PSE, the Capital Market Authority, the brokerage firms and the other experts we interviewed whose comments and ideas we benefited from. For the same reason, I am grateful to all the participants at the workshop during which the study was presented and discussed. Thanks also go to Dr. Basem Makhool, Dr. Atef Alawneh, and Dr. Sulaiman Abbadi for reviewing and refereeing the study. Last but not least, I want to extend my thanks. | STOCK RETURNS AND INFLATION THE IMPACT OF INFLATION TARGETING ÀLEXAnDRơs KontoniKAsa Alberto MonTAGnoL AnD Nicola SRAGnoLoc a Department of Economics University of Glasgow Glasgow UK Department of Economics University of Stirling UK c Brunel Business School Department of Economics and Finance London UK August 24 2006 Abstract This paper investigates the dynamic interaction between inflation and stock returns in four inflation targeting countries. We find that following the introduction of formal targets inflation persistence and the magnitude of volatility spillovers between inflation and stock returns have been reduced. Keywords Multivariate GARCH Inflation Stock prices Volatility. JEL Classification C22 E31 E44 E52 1 Introduction Ever since the early 1990s some countries adopted inflation targeting as a new monetary policy strategy. So far these regimes are claimed to be a success since inflation persistence declined inflation rates became lower and less volatile and inflation expectations were anchored at low levels 1 . Furthermore it is expected that a regime consistent with low and stable inflation tends as a by-product to promote financial market stability Bordo and Wheelock 1998 . Given that stock returns measure nominal payoffs when inflation of goods prices is uncertain the volatility of nominal asset returns should reflect inflation volatility Schwert 1989 hence lower inflation variability should exert a calming effect on stock market volatility. This view draws support from a theoretical literature that emphasizes the importance of informational asymmetries in credit markets and shows how higher inflation adversely affects credit market frictions with negative consequences for financial sector performance see . Huybens and Smith 1999 2. Corresponding author A. Kontonikas. Tel 44 141 330 6866. Fax 44 141 330 4940. Email 1 See Kontonikas 2004 for UK evidence. 2Moreover a number of empirical studies finds a significant

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