An empirical analysis of stock returns, inflation, and interest rates in the Pacific-Basin countries

This study evaluates the Fisher hypothesis that the expected nominal return on assets consists of a "real" rate plus expected inflation. In an efficient financial market, expected inflation is embodied in current interest rates, and the hypothesis gives rise to arbitrage rationale for investors in the choice between financial assets and real assets in a single country.;The data of this study is germane to 10 countries in the Pacific-Basin. The primary objective of this study is two-fold: (1) to test the relations between stock returns and inflation and between interest rates and inflation and (2) to investigate causal relations and dynamic interactions among stock returns, inflation, and interest rates. Corollary to these objectives are empirical verification of three secondary goals: to examine the statistical properties of time-series data used, to evaluate the general efficiency of capital markets in the individual countries under study, and to ascertain the applicability of the Fisher hypothesis in developing capital markets.;This study applies integration, cointegration, Granger causality, and vector autoregressive (VAR) techniques to investigate three hypotheses. First, it tests for unit roots in nominal interest rates and inflation, where the null hypothesis is a non-stationary unit root process. Second, it tests whether or not ex ante nominal interest rates and realized inflation are cointegrated, as the Fisher hypothesis predicts they will be. Third, it examines for causality as well as dynamic interactions among stock returns, inflation, and interest rates.;The generalized Fisher effect that real rates of return on common stocks are independent of inflationary expectations is soundly rejected for every individual financial market under study. Furthermore, the results of the VAR model indicate the lack of a unidirectional causality between stock returns and inflation. This study also fails to find a consistent positive response either of inflation to shocks in stock returns or of stock returns to shocks in inflation in all countries. On the whole these findings are consistent with those of previous studies for the post-war periods.;The Augmented Dickey-Fuller test reveals that inflation, short- and long-term interest rates, and the spread between long-term interest rates and inflation are non-stationary unit root processes for all countries. The study also finds that inflation and short- and long-term interest rates do not share a common trend; that is, they are not cointegrated. Additionally, the VAR model results are consistent with the cointegration tests results; that is, nominal interest rates are poor predictors for future inflation in the Pacific-Basin countries.