Inflation, a persistent concern in economics and finance, significantly influences financial market stability. The Federal Reserve's unprecedented interest rate hikes in 2023 to combat inflation created substantial market fluctuations, highlighting the need to understand inflation's impact on financial markets. This study aims to examine this impact using data from the US market between 2000 and 2023, focusing on the Consumer Price Index (CPI) as a measure of inflation and the Nasdaq and S&P 500 indices as proxies for financial market performance. The study's importance lies in providing insights into the complex relationship between inflation and market performance, informing policy recommendations and investor strategies in an era marked by fluctuating inflation rates and central bank interventions. The research seeks to clarify the often-conflicting viewpoints on inflation’s effect on financial markets and provide evidence-based conclusions that can inform both investors and policymakers.

Existing literature extensively explores the multifaceted relationship between inflation and financial market performance. Studies have established robust correlations between inflation and various financial indicators, including stock markets, investment portfolios, and overall financial activity. Some research highlights a positive correlation between real activity, bank lending, and stock market trading volume. Conversely, other studies show a significant negative correlation between inflation and real equity returns, especially in the long term. The non-linear impact of inflation on banking and stock market activities, where the impact diminishes with higher inflation levels, has also been noted. Furthermore, the literature emphasizes the importance of accurate inflation data and the use of sophisticated models, such as dynamic factor models, to capture the complexities of inflation across different consumer price changes. Macroeconomic challenges posed by inflation and the effectiveness of monetary policies have also been subjects of extensive research, including the challenges in predicting short-term inflation trends and the impact of numerical inflation targets on inflation expectations. Finally, studies delve into the interrelation between financial and economic volatility, examining asset prices, risk, and interest rates within portfolio behaviors. This paper builds on this existing body of work by providing a comprehensive empirical analysis of the relationship between inflation and financial market performance, considering temporal variations in this relationship.

This study employs an empirical approach using data from the Federal Reserve Economic Data (FRED) spanning from 2000 to 2023. The primary variables include the Consumer Price Index (CPI) as a measure of inflation, and the Nasdaq and S&P 500 indices as measures of financial market performance. The methodology involves several key steps: First, descriptive statistics are presented to summarize the data. Second, correlation analysis visually explores the relationship between the CPI and the financial market indices. Third, a benchmark linear regression model is employed to quantify the impact of the CPI on the Nasdaq index (Yᵢ = b₀ + b₁Xᵢ + εᵢ, where Yᵢ represents financial market performance, Xᵢ represents inflation (CPI), and εᵢ represents the residual). The robustness of this benchmark regression is tested by substituting the CPI with the median CPI and the Nasdaq with the S&P 500 index. Fourth, a temporal heterogeneity analysis is conducted by dividing the data into periods before and after significant economic events, such as the 2007 financial crisis and the COVID-19 pandemic, to analyze how the relationship between inflation and financial market performance changes over time. This analysis allows the researchers to identify whether the relationship between the variables is consistent throughout the studied time period or exhibits shifts due to major economic shocks.

The correlation analysis reveals a predominantly positive correlation between the CPI and the Nasdaq index. The benchmark regression confirms this, showing a statistically significant and positive impact of the CPI on the Nasdaq index. Robustness tests, using the median CPI and the S&P 500 index, support these findings. However, the temporal heterogeneity analysis reveals a more nuanced relationship. Before the 2007 financial crisis, the CPI showed a negative correlation with the Nasdaq. Post-2007 crisis and pre-COVID-19, a positive correlation was observed. After the COVID-19 pandemic's onset, the correlation between the CPI and the market indices weakened considerably. This suggests that the impact of inflation on financial markets is not consistently positive and is influenced by major economic events. Specific regression coefficients are presented in Tables 2 and 3 within the paper, illustrating the magnitude of these effects and their statistical significance.

The findings highlight the dynamic and context-dependent relationship between inflation and financial market performance. While a generally positive correlation is observed, the impact of inflation varies significantly across different periods marked by major economic shocks. The negative correlation pre-2007 may be attributed to the factors leading up to the crisis and investor responses to uncertainty. The positive correlation post-2007 but pre-COVID-19 may reflect different investor behaviours and policy responses to manage inflation. The weaker correlation post-COVID-19 might be due to the unique nature of the pandemic and its multifaceted impacts on the global economy. These findings challenge the notion of a uniformly positive or negative relationship between inflation and financial markets, emphasizing the need to consider temporal heterogeneity and contextual factors when analyzing this relationship. The study's results have significant implications for investors and policymakers, highlighting the importance of understanding the time-varying nature of the inflation-market performance link.

This study provides valuable insights into the dynamic relationship between inflation and financial market performance. The findings demonstrate the importance of considering the temporal heterogeneity of this relationship, with significant economic events altering the correlation between inflation and market indicators. Future research should incorporate additional macroeconomic variables and delve deeper into the micro-level impacts on individual consumers and firms. Expanding the study to encompass different geographical regions would also enrich the understanding of the global implications of inflation dynamics on financial markets.

The study primarily focuses on the US market, limiting the generalizability of findings to other economies. While the study considers two significant economic events, other factors that could affect market performance were not explicitly examined. The reliance on linear regression models might not fully capture the complex non-linear relationships between inflation and financial markets. Future research should address these limitations by incorporating a broader range of variables, different modeling approaches, and a more diverse geographical scope.