Inflation And Stock Price Behavior Economics Essay

This paper examines the relationship between inflation and stock price behavior in Malaysian stock market. By using a simple regression model to relate stock prices to inflation and other controlled variables, a monthly data from the year 2008 and 2011 is used to test this model. It is found that that inflation shows a negative relationship with stock prices.

Introduction

The relationship of stock prices and inflation has been the subject of many research papers. Researchers are interested to see the relationship between stock prices in most developing countries. In this paper, we are going to see how inflation reacts with stock prices in Malaysian stock market through various channels of economic factors.

Stock market

A market can be defined as a price where both buyers and sellers can communicate with each other to transfer their goods and services. A market is important for the smoothness of an operation in every country’s economy (Reily and Brown, 2000). The primary role of a stock market not only as a predictor of an economic activity, and according to (Falkena,Fourie and Kok,1988) the functions of stock market is to evaluate and manage securities, channel savings into investment and provide market liquidity by converting investment into cash. The Bursa Malaysia or Malaysia Exchange, MYX, which previously known as Kuala Lumpur Stock Exchange, KLSE is where the performance of Malaysian stock market is being controlled. After they changed their name to Bursa Malaysia, it became a demutualized exchange and consists of the main board, a second board and MESDAQ with total market capitalization of MYR 700 billion. Kuala Lumpur Composite Index is the main index for Bursa Malaysia, but in 2006, Bursa Malaysia and FTSE developed a new index series known as FTSE Bursa Malaysia Index. About 986 listed companies are in the Bursa Malaysia as of December 31, 2007 with a combined market capitalization of $325 billion. Today for about 1000 diversified companies, which is listed in the main board, is being tracked by Bursa Malaysia. Bursa Malaysia is not only operate and regulate a fully integrated exchange offerings by listing, trading, clearing, settlement and depository services but also provide a various form of products like equities, derivatives, offshore listings and services and bonds and Islamic offerings. The performance of Malaysian stock market shows different performance everyday. From 1977 until 2012, the stock market performance shows a high index point in the recent market activity in November of 2012 while a low index point in April of 1977. For the development of the Malaysian capital market, Bursa Malaysia is committed in providing a competitive and vibrant infrastructure of marketplace.

Inflation

Inflation is important in our economic issues. It is known as the measures in prices for goods and services like food, clothing and other. Inflation also tracks how these prices change over time. It is also plays an important role in setting economic policy. Inflation can be divided into two types, the expected inflation and unexpected inflation. Expected inflation is a result that economists and consumers plan from year to year, while the unexpected inflation is beyond from what has expected from economist and consumers. Theoretically unexpected inflation gives a very harmful effect to economist and consumers. In financial theory, there are two types of calculation to measures inflation that is the consumer price index (CPI) and producer price index (PPI). The consumer price index measures the price changes in all types of goods and services and it usually identifies whether the country is facing inflation or deflation. While the producer price index measures the average changes over time in the selling price of domestic producers of goods and services. The most famous measure of inflation in Malaysia is the consumer price index and the GDP deflator, which measures the whole economy.

Inflation in Malaysia

Malaysia experiences a few inflation series in developing the country’s stable economy. Inflation rose significantly in both the international and domestic markets in 1973. This is cause by the raise in oil prices that also effect the world inflation. The second episode of high inflation is during the year 1980 and 1981, which also cause by the increase in price of oil. This causes the prices of industrial raw materials and investment of goods and services to increase rapidly. Another outburst in inflation in Malaysia happens during the Asian financial crisis in the year 1997 where the interest rates, fuel prices and price of goods and services increase dramatically. Although, Malaysia faces a few outbursts in the behavior of inflation, the able to maintain a stable inflation rate after the Asian financial crisis.

Problem statement

Investing in developing countries is rather risky. There is no exception that even foreigner who wants to invest in different countries also have a major risk by doing so. Malaysian stock market performance of 1000 largest companies listed in the Bursa Malaysia’s main board shows different performance everyday. Whether it goes up or down, it is affected by different kinds of economic factors. Historically, from the year 1977 until 2012, Malaysian stock indices show the highest performance during the recent market activity as in November of 2012 and the lowest is during April 0f 1977. In a recent event, trading exchange was suspended for about an hour because of a few crises like United States of subprime mortgage crisis, which is on the March 10th of 2008. And the political crisis caused by 12th General election. These show that a few events that might triggers the behavioral of stock prices.

Like other developing countries, Malaysia also experiences different types of inflation series. During the year 1973 until 1974, Malaysian economic activities experience a high series of inflation, while inflation is low during the year 1985 until 1987. Although Malaysian economy experiences a few ups and downs to achieve a stable economic level, they were able to maintain a stable inflation rate during the high economic growth between the year 1988 until 1996. They also experience a high level of inflation rate during the Asian financial crisis in 1997 and became stable a year after.

It is shown that both Malaysian stock prices and inflation experience a few ups and downs in the development of economic activity. This paper will investigate how these two variables relate to each other and how they are affected with other economic variables. Whether they show a positive or negative relationship through different types economic variables.

Objectives

The overall objectives in this study are to examine the relationship between inflation and the stock price in the Malaysian stock market. The main objective in this study is to examine whether the stock price shows a negative effect or positive effect towards inflation in through various channels of economic factors.

Literature review

There are many researchers have been studied the behavior of stock price and inflation. There are different kinds of results showed by previous researches by using different kind of controlled economic variable. In this section, we will see how the results of previous researchers will affect this study.

A large number of studies like Fama and Schwert (1977), Schwert(1981) and Fama (1981) found that the relationship between stock price and inflation is negative. There are also a few researchers found the same findings like Nelson (1976), Kaul and Seyhun (1990), Cochran and Defina (1991). However, there are also a few studies that found no significant relationship between these two variables, which are according to Pearce and Roley (1985) and Hardouvelis (1988)

Fama (1981) who is the person to uncovers the relationship between stock prices and inflation. Fama states that stock and inflation relates differently by different kind of economic variables that is used as controlled variable. Fama used money demand inflation model where money demand is the controlled variable to relate the two variables, Fama maintains a positive relationship between real stock return with real economic activities combined with a fixed negative relationship between inflation and real economic activity. Through these combinations, it is found that real stock returns shows an inverse relationship to inflation by keeping the money demand fixed.

Geske and Roll (1983) used a different fixed variable in their findings. They suggested that money demand is not only the cause of negative effect between the two variables, but money supply also shows the similar effect with Fama’s theory. They conclude that stock returns and expected inflation can vary inversely, but for a different reason and in a reverse manner than suggested by Fama (1981)

Kaul (1987) argued that monetary tightening also cause the negative relation between these two variables. During the U.S post-war period, they suffer a monetary tightening. This will cause the increase in both money demand and money supply increases and at the same time will cause inflation to decrease and stock price to increase. This suggests that stock price and inflation is negatively related.

Hess and Lee (1999) also suggest the same thing regarding the supply and demand of money where if there is any imbalances of these two-fixed variable, it will cause positive relationship between stock prices and inflation.

For time series analysis, there are a number of researchers that used this type of analysis to support their findings. For example Anari and Kolari (2001) states that the stock price shows a negative relation to inflation in the short run and positive relationship in the long run. Boudoukh and Richardson (1993) also states the same result where stock returns are inversely related to realized inflation, as well as expected inflation in the short run, but maybe positively related to inflation in the long run. Udegbunam and Eriki (2001) who studied the behavior of stock prices and inflation in Nigeria also agrees that both short-term and long-term fluctuations will cause negative relationship between stock price and inflation

Saryal (2007) examines the impact of inflation and stock market volatility in two different countries with different rates of inflation, Canada and Turkey. Canada is a developed country with a low inflation rate, while Turkey is and emerging market country with high inflation. The result showed that the higher the rate of inflation, the higher the nominal stock returns which conclude that Turkey had a stronger impact in stock market volatility than in Canada.

Although the primary focus of this study is on the behavior of stock price and inflation in Malaysia, there is a lot of evidence from previous findings from various developing countries that strongly believe that inflation through other various variables will give negative effect towards stock prices. Inflation is not only effect the behavior of stock prices, but also other economic variables like the interest rate and the economic activity which is measured by gross domestic product (GDP).

According to Boeckh and Coghlan (1982) inflation has a greater impact on stock prices than interest rate. This is because interest rate typically moves in the same direction with inflation. While a large number of results states that interest rate have strong negative influence on stock prices through a number of channels such as when the interest rates increases, it will raise the rate of discount and hence, it will decrease in stock price. Through this relationship, by keeping the interest rate fixed, it is found that inflation exerts a negative impact on stock prices.

According to Geetha and Mohidin (2011) stock return shows the movements of market. Unfortunately, stock returns can be influence by other economical activities and thus create a global anomaly. Especially, when there’s a slight increase in inflation, it will affect the international prices and commodities prices. However, the impact of both inflation and GDP would give shock to the stock market of a country. Udegbunam and Eriki (2001) state the same finding that is an increase in GDP is expected to increase the firm’s profitability and therefore the firm’s stock prices.

The results provide a rigid support that our focus on the inflation through all types of economic variables like interest rate and gross domestic product will produce the significant results of negative relationship to inflation.

Method

We examine the relationship between inflation and stock prices in Malaysia over the period of 2008 until 2011. As already indicated, the data for this study consists of monthly time series of the variables of the model for the period 2009 and 2011. The variables of this study are from interest rate (Malaysia Treasury bill rate), inflation (CPI), gross domestic product (GDP) and stock indices. The data is obtained from various sources from the Bursa Malaysia (BM), Department of Statistic Malaysia (DOS), and Bank Negara Malaysia (BNM)

Stock Price indices, Inflation and control variable:

The data for this study consists of monthly time series data from the year 2008 until 2011. This data is taken from Bursa Malaysia. The other variables of this study are stand from inflation rate, gross domestic product and interest rates. The inflation rates used in this study are calculated in consumer price indices. The consumer price indices are reported as monthly data in Department of Statistic Malaysia. While the data for GDP and interest rate is taken from Bank Negara Malaysia (BNM) and Department of Statistic Malaysia.

The linear form of the basic model is:

Where

SP= stock price index

INF= inflation rate

GDP= gross domestic product

INT= rate of interest

e= error term

t= time

the prior signs to the coefficients are

Conclusion

In this paper, we are examining the behavior of inflation and stock price in Malaysian market. A simple stock price model and includes other control variables that are the other key determinants of stock prices. By using the simple regression method, the expected result shows that inflation shows a negative relationship on the Malaysian stock market through other various economical variables………….