Unexpected Inflation and Stock Returns Revisited - Evidence from Israel

Abstract

This paper examines the effects of unexpected inflation on stock prices, using Israeli data which provide a direct market-based measure of unexpected inflation: the price reaction of CPI-linked bonds following the CPI announcement. The results show that stock prices have a strong negative relationship with unexpected inflation. The Israeli setting rules out a number of hypotheses advanced in the United States to explain this relationship, such as nominal contracting, inflationary taxation, wealth transfer, and money illusion. This suggests that the negative effect of unexpected inflation is due to its negative association with real activity and its real economic cost.

JEL Classification: G15