Fed even begins to take its stabilizing actions. Whatever the reasons, Fed
policy actions, at least since 2000, have not evoked the same responses in
the equity market as they had in the past.STOCKS AS HEDGES AGAINST INFLATION
Although the central bank has the power to moderate (but not eliminate)
the business cycle, its policy has the greatest influence on inflation. As
noted above, the inflation of the 1970s was due to the overexpansion of
the money supply, which was an action the central bank took in the vain
hope that it could offset the contractionary effect of the OPEC oil supply
restrictions. This expansionary monetary policy brought inflation to
double-digit levels in most industrialized economies peaking at 13 per-
cent per year in the United States and exceeding 24 percent in the United
Kingdom.
In contrast to the returns of fixed-income assets over long periods
of time, the historical evidence is convincing that the returns on stocks
over the same time periods have kept pace with inflation. Since stocks
are claims on the earnings of real assets—assets whose value is intrinsi-
cally related to labor and capital—it is reasonable to expect that their
long-term returns will not be influenced by inflation. For example, the
60-year period since World War II has been the most inflationary long-
term period in our history, yet the real returns on stocks have exceeded
that of the previous 150 years. The ability of an asset such as stocks to
maintain its purchasing power during periods of inflation makes equi-
ties an inflation hedge.
Indeed, stocks were widely praised in the 1950s as hedges against
rising consumer prices. As noted in Chapter 7, many investors stayed
with stocks, despite seeing the dividend yield on equities fall below the
interest rate on long-term bonds for the first time. In the 1970s, however,
stocks were ravaged by inflation, and it became unfashionable to view
equity as an effective hedge against inflation.
What does the evidence say about the effectiveness of stocks as an
inflation hedge? The annual compound returns on stocks, bonds, and
Treasury bills against inflation over 1-year and 30-year holding periods
from 1871 to 2006 are shown in Figure 11-2.
These figures indicate that neither stocks nor bonds nor bills are
good short-term hedges against inflation. Short-term real returns on
these financial assets are highest when the inflation rates are low, and
their returns fall as inflation increases. But the real returns on stocks are
virtually unaffected by the inflation rate over longer horizons. Bonds, onCHAPTER 11 Gold, Monetary Policy, and Inflation 199