Structural breaks and the Fisher hypothesis in bond and stock markets

We attempt to resolve the empirical puzzle in the Fisher effect that nominal stock returns are negatively related to expected inflation. We postulate that this negative relation is caused by simultaneous changes in expected inflation, ex ante real interest rates on bonds and ex ante real returns on stocks due to supply shocks. We find that ex ante real interest rates and real stock returns are not independent of the expected inflation over the structural break subperiods chosen a priori to coincide with the oil price shocks of 1973 and 1979. As an alternative procedure, we employ the Cumulative Sum (CUSUM) test, in which the timing of structural breaks is based completely on sample data without requiring a priori information. The CUSUM test identifies a structural break in 1982Q1, which coincides approximately with the Federal Open Market Committee's (FOMC) deemphasis of the monetary aggregates as intermediate targets. We show that the Fisher effect cannot be rejected after the structural break identified by the CUSUM test in either the aggregate bond or stock market. In sum, our results provide evidence that the puzzling relation of expected inflation and nominal stock returns is limited to the subperiod before the 1982Q1 break.