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The announcement of a second round of quantitative easing has raised inflation expectations and stock prices. Given that it represents a claim to real resources, the return on a common stock is positively correlated with the rate of inflation, over long periods of time, as the value of the resources generally rises with inflation.

In the short-run, the relation between stock prices and the rate of inflation is complicated and unclear. Despite inflation above the generally-acceptable 3% rate, empirical evidence indicates that it is possible for stocks to be neither a complete nor consistent hedge against inflation.

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According to the traditional concept of an inflation hedge, a common stock is said to be a hedge against inflation if the share price, dividends, or some combination thereof, rise at a nominal rate which is greater than, or equal to, the rate of inflation. In other words, the real rate of return must be either greater than, or equal to, zero.

The traditional viewpoint is flawed because the investor is not compensated for time and risk if the real rate of return is zero. In order to be considered as a hedge against inflation, the minimum nominal return of a stock must be equal to the required rate of return (which is determined by some financial model) multiplied by the rate of inflation. Historical data indicates that stocks are inadequate inflation hedges during periods of relatively-high inflation.

It is argued that stockholders do not benefit from unexpectedly-high inflation because the effective tax rate on real corporate income is very sensitive to the rate of inflation. Under the FIFO accounting method, a general rise in prices causes the cost of goods sold to be understated, and leads to illusory inflation profits as a rise in the nominal value of inventory is treated as income.

Likewise, a significant rise in the price level causes a fall in real depreciation expenses and the value of the tax shield. Thus, stockholders do not benefit from illusory inflation income because it is taxed away. However, the fall in the real value of a firm’s debt is beneficial to stockholders, but a lower real debt burden is somewhat neutralized by a smaller tax shield as the real value of interest payments declines as well.

If stocks are used as a hedge against unanticipated inflation, it should be kept in mind that, in addition to being compensated for inflation, the investor must receive a return for time and risk. The best defense against unexpected inflation is a firm which does not use the FIFO method (or uses the LIFO approach) to account for inventory, possesses few depreciable assets, and has a relatively-high debt-equity ratio.

Ultimately, the sensitivity of product and input prices, as well as the interest rate, to the unanticipated change in inflation also has an important on effect on stock prices.

Disclosure: No positions.

Source: Stocks as an Inflation Hedge