Monetary policy, inflation and stock returns: evidence from the United Kingdom

Abstract

This thesis analyses the response of aggregate and sectoral stock returns to monetary policy announcements and inflation in the United Kingdom. Given the unique monetary policy framework, the monetary policymaking process and inflation target of the United Kingdom are different from other countries in many aspects, investigating the UK case could add international evidence to the current literature. This thesis contains three main parts: (i) monetary policy and stock returns, examining the impact of monetary policy announcements on stock returns and stock market volatility under different monetary policy regimes, especially before and after the independence of the Bank of England in 1997; (ii) inflation and stock returns, investigating the issues whether common stocks are a hedge against inflation in short, medium and long-term and under different inflationary economies and regimes; (iii) corporate financing mix and inflation exposure, testing how corporate financing mix affects the exposure of common stocks to inflation. The results suggest that monetary policy announcements negatively affect stock returns and significantly impact stock market volatility. The responses of stock returns and stock market volatility vary before and after May 1997, when the Bank of England gained independence, which suggests that a change in the monetary policymaking process tends to affect the responses of stock markets. The research also uncovers the fact that the UK stock market fails to hedge against inflation in short and medium-term, but provides a good hedge against inflation in long-term. Different inflationary economies or regimes also affect the relationship between inflation and stock returns. In addition, this thesis finds support for the nominal contracting effect suggesting that firms with higher debtors gain while firms with higher creditors lose from higher-than-expected inflation. The empirical mixture of the results found in the relationship between inflation and stock returns is likely to be explained by the nominal contracting hypothesis.