the rate of inflation. In theory the returns from stocks will keep up with
rising prices and stocks will be a complete inflation hedge.
Nonneutral Inflation: Supply-Side Effects
The invariance of stock prices to the inflation rate holds when inflation is
purely monetary in nature, influencing costs and profits equally. But there
are many circumstances in which earnings cannot keep up with inflation.
Stocks declined during the 1970s because the restriction in OPEC oil sup-
plies dramatically increased energy costs. Firms were not able to raise the
prices of their output by as much as the soaring cost of their energy inputs.
Earlier in the chapter it was noted that the inflation of the 1970s was
the result of bad monetary policy trying to offset the contractionary effect
of OPEC’s oil price hikes. Yet one should not minimize the harm done by
OPEC’s policies on U.S. corporate profits. U.S. manufacturers, who for
years had thrived on low energy prices, were totally unprepared to deal
with surging energy costs. The recession that followed the first OPEC oil
squeeze pummeled the stock market. Productivity plummeted, and by
the end of 1974 real stock prices, measured by the Dow Jones averages,
had fallen 65 percent from the January 1966 high—the largest decline
since the crash of 1929. Pessimism ran so deep that nearly half of all
Americans in August 1974 believed the economy was heading toward a
depression such as the one the nation had experienced in the 1930s.^11
Inflation can also harm stock prices since it increases investors’ fears
that the central bank will take restrictive action by raising short-term real
interest rates. Such restrictive policies are often followed by an economic
slowdown, which also depresses stock prices. This is another good ra-
tionale for investors to take stock prices down when inflation rises.
Looking at international markets, inflation, especially in less-devel-
oped countries, is also closely linked with large government budget
deficits and excessive government spending. Inflation therefore often
signals that the government is taking too large a role in the economy,
which leads to lower growth, lower corporate profits, and lower stock
prices. In short, there are many good economic reasons why stock prices
should fall in response to increased inflation.
Taxes on Corporate Earnings
Another very important reason why stocks are poor short-term hedges
against inflation is the tax code. There are two significant areas in which
202 PART 3 How the Economic Environment Impacts Stocks
(^11) Gallup poll taken August 2 to 5, 1974.