The relationship between inflation and stock prices - a case study of the Nairobi stock exchange

Abstract

The relationship between stock prices and inflation has intrigued researchers who have attempted to explain how a nominal variable such as inflation should determine a real variable (asset prices). Recent research findings have established the existence of a negative relationship between a negative relationship between stock prices and inflation. These findings contradict the hypothesis by Fisher (1930) who argued that stock prices should be positively related with expected inflation, providing a hedge against rising prices. This study investigated the relationship between inflation and stock prices at the Nairobi Stock Exchange. The study's objectives were to specify and estimate the functional relation-hip between inflation and stock prices at the Nairobi Stock Exchange, to asses the validity of the Fisherian hypothesis using the stock prices at the Nairobi Stock Exchange and to draw policy conclusions and recommendations based on the empirical findings An empirical investigation was conducted using monthly data on selected stocks from a sample of six companies listed at the Nairobi Stock exchange, for the period 2002-2006. The OLS estimation technique was employed to estimate a single equation with the real returns as the dependent variable and explanatory variables as actual inflation, expected inflation and information dummy. A specification associated with error correction modeling (ECM) was applied to capture long run equilibrium after the variables were difference to make them stationary. The study reports a negative relationship between stock returns and expected inflation contrary to Fishers (1930) hypothesis. The study findings however depict a positive relationship between actual inflation and stock prices and the dividend information dummy. The findings of this study shed light on the price discovery process at the Nairobi Stock Exchange indicating that investors fail to factor in the effect of inflation on stocks at the stock exchange. The study recommends increased investor education to remedy this anomaly.