Although inflation is expected to dip to zero in the coming months —and there’s even some talk of deflation — the Bank of Canada will still be working hard to maintain its target inflation rate of 2% throughout this year.

Is even such relatively modest inflation bad for stocks? The simple answer is: not necessarily, even though investors typically associate higher inflation rates with economic disarray, poor company profits and generally lower purchasing power.

With inflation at 4%, for example, a dollar of profit that a company will earn a year from now is worth only 96¢ in today’s dollars. To some analysts, this means the company’s financials may be overstated as revenue and earnings reflect this inflation, over and above any added value generated by the company. So, depending on the industry, the value of the company’s future earnings should be lower, making its stock less attractive at the same time.

Not looking at money in terms of constant buying power is called the “money illusion,” and it can certainly get people in trouble if they fail to keep an eye on their own purchasing power. But the mere presence of inflation also suggests that many companies will successfully pass along higher prices to their customers.

In fact, corporate profits have tended to grow faster when inflation is higher, suggests a study conducted a few years ago by Harvard University economist John Campbell entitled Inflation Illusion and Stock Prices.

Although higher inflation does lead to a greater discounting of future earnings, those earnings also tend to be greater than they might otherwise have been, Campbell’s report noted. Even though inflation might make investors more risk-averse and thus drive up the hazard pay, or the “risk premium,” the net result is that future earnings actually remain relatively stable in the face of rising inflation, allowing stocks to hold their own.

So, which concept better explains the relationship between the inflation rate and stock market returns: the idea of the money illusion, or the more typical theory of supply and demand? The former proposes that most investors have trouble determining the required rate of return from equities as the inflation rate rises or falls, thereby improperly valuing stocks. The latter proposes that it’s more the moves in the aggregate investor demand that drive the topsy-turvy relationship between the inflation rate and stock prices.

In a recent paper entitled Stock Returns and Inflation Revisited, University of Houston professor Bong-Soo Lee re-examined these hypotheses using long-run U.S. data. Looking at stock return and inflation rate numbers from 1927 to 2007, Lee’s study found that the relationship between the inflation rate and stock returns in the U.S. was largely positive in the pre-Second World War period, more negative in the postwar years and slightly negative for the entire sample period.

In other words, a high inflation rate indicated stock undervaluation in the postwar period but overvaluation pre-war. After the war, aggregate supply shocks suggested a negative relationship between the inflation rate and stock returns, the biggest variable being increases in oil prices that elevated the inflation rate but depressing stock prices at the same time.

The inflation illusion hypothesis can explain the postwar relationship between the inflation rate and stock returns, but not the pre-war results, Lee’s paper concludes. However, a mixture of the two does explain both, the paper adds.

Of course, there is always the pace of change to consider. In periods of low but rising inflation, stocks do suffer, according to independent financial research firm Ned Davis Research Inc. of Venice, Fla.: looking at stock market results from 1926 through to early 2008, that study found that stocks gained by less than 0.5% a year, on average, in periods when inflation accelerated rapidly.

However, any upcoming changes in the consumer price index, a proxy for the inflation rate, are expected to be gradual, suggesting that stocks — even though they are often hurt by rising prices in the short term — may be actually be investors’ best long-term hedge against inflation. IE