Inflation and stock prices

The classic proposition that stock prices can be expected, in the long-run, to rise in proportion to the increases in the price level has been challenged by several researchers suggesting there is a negative relationship between stock returns and inflation.  Since the issue can be decided only empirically, in this brief essay we use cointegration, Granger causality, and an error correction model to confront the issue of whether stock prices are a good hedge against inflation in the long-run.  Cointegration results showed that stock returns and inflation shared a common stochastic trend thus tending to move together in the long-run.  In addition, Granger causality test results suggested that causality runs from inflation to stock returns.  Finally, the error correction model confirms the Fisher hypothesis that stock prices rise in proportion to the rise in the price level.