Asymmetric and cross-sectional effects of inflation on stock returns under varying monetary conditions

This study examines the relationship between returns on portfolios, comprised of stocks of various size and book values, and changes in inflation. The relationship is evaluated in the context of positive and negative changes in expected and unexpected inflation, and expansionary and contractionary monetary policy conditions. Results from the panel estimation procedure show that inflation has a strong asymmetric impact on stock returns, and this may explain why simply summing up inflation shocks, as in previous studies, could lead to misleading conclusions. This article concludes that the nature of this asymmetric relationship is complex and contingent on several factors including the state of the monetary policy, whether one is examining expected or unexpected inflation shocks, and the size and book values of the stocks. In general, a positive shock to expected and unexpected inflation has a favourable impact on stock returns during monetary expansion, but not during monetary tightening.