The dimension of the stock price-inflation puzzle that generated the greatest sustained academic interest, however, was the apparent negative relation between expected inflation and subsequent stock returns. The explanation that garnered early support was known as the “proxy hypothesis”. First articulated by Fama (1981), this hypothesis held that (i) a rise in inflation augurs a decline in real economic activity; and (ii) the stock market anticipates the decline in corporate earnings associated with this slowdown. Hence, in regressions of stock returns on inflation--expected inflation in Fama’s formulation--the effect of inflation is spurious; that is, inflation merely acts as a proxy for the true fundamentals,.
