CAUSAL RELATIONS AMONG STOCK RETURNS, INFLATION, REA L ACTIVITY, AND INTEREST RATES: EVIDENCE FROM JAPAN Mohammad Najand Gregory Noronha zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA The puzzling negative relationship between stock returns and inflation is well documented in the finance literature. However, the direction of causality and the specification of the relationship between stock returns and inflation has not been fully resolved. The examination of this puzzle with the new and potentially more powerful ‘ state space’ analysis provides an opportunity to better specify the nature of this relationship as well as the direction of causality. Expected inflation, changes in expected inflation, and unexpected inflation are negatively related to stock returns. This surprising result was first published by Nelson (1976), Bodie (1976), and Jaffe and Mandelker (1976). Fama and Schwert (1977) also investigated the relationship between stock returns and inflation. All of the above authors reported finding a strong negative relationship. There have been a number of different explanations for the existence of this negative relationship. In a detailed examination of the ‘monetarist’ position, Nel- son (1979) reported that “ Inflation shocks result in corresponding changes in output of the opposite sign.” The real activity hypothesis, which was further, investigated by Fama (1981) states that the negative relationship between stock returns and inflation proxies for the positive relationship between stock returns and real variables. The observed negative correlation between stock returns and inflation is caused by the negative relation between inflation and real activity. Following Nelson, Fama relies on a combination of money demand theory and the quantity theory of money to explain these results. Geske and Roll (1983) elab- orate on Fama’s explanation, maintaining that movements in stock prices cause changes in inflationary expectations. An unanticipated drop in stock prices is a signal for a drop in anticipated economic activity and, therefore, in government revenues. Given largely fixed government expenditures this leads to the expecta- Mohammad Najand, Finance Department, Old Dominion University, Norfolk, VA 23259; Gregory Noronha, School of Management, Arizona State University West, 4701 W. Thunderbird Road, Phoe- nix, AZ 85069-7100. Global Finance Journal, 9(l): 71-80 Copyright 0 1998 by JAI Press Inc. ISSN: 10440283 AU rights of reproduction in any form reserved.