Real and Nominal Interest Rates, 1960-2010 20.0 15.0 10.0 5.0 0.0 -5.0 -10.0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year Interest rate, % Nominal rate Real rate This graph plots the nominal and real interest rates on 3-month Treasury bills. The real rate is the nominal rate minus the inflation rate over the previous year. Source: Federal Reserve Bank of St. LouisThe Fed and the Stock Market Fed raises interest rates Safe interest rate (isafe) rises. Uncertainty rises, so risk premiums (ø) rise. Risk-adjusted interest rates (isafe+ø) rise. Economy slows, so expected stock dividends fall. Present value of expected dividends falls Stock prices fall. When the Fed raises interest rates unexpectedly, a series of effects reduces stock prices. When the Fed lowers rates unexpectedly, opposite effects occur and stock prices rise. 2008 Fed sharply lowers interest rate in response to banking crisis and recession i safe falls Banking crisis increases uncertainty, risk premium rises Net effect is rise in corporate bond rate Stock prices fall Risk-adjusted interest rates (isafe+ø) rise.CHAPTER 3 Asset Prices and Interest Rates Bond Prices, Maturity, and Interest RatesEvidence for Bubbles? Each point in this graph represents a year between 1918 and 2000. The horizontal axis is the price-earnings ratio for stocks in the S&P 500, based on average earnings over the previous 10 years. The vertical axis is the average percentage change in S&P prices over the following 10 years, adjusted for inflation. (The 10-year change after 2000 is estimated with data through 2009). 15.0 10.0 5.0 0 -5.0 -10.0 P/E ratio, S&P 500 Subsequent price change, % 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0 45.0 The orange “best fit” line through the data points indicates a negative relationship between these two variables: when the P/E ratio is high, stock prices are likely to grow slowly or fall over the following 10 years. Source: Robert Shiller, Yale University (www.econ.yale.edu/~shiller/data.htm)JapanJapan: Land Prices and Values0501001502002501955 1960 1965 1970 1975 1980 1985 1990 1995 2000234567Land Price Index: 1955=1 (left scale)Land Value/Household Disposable Income (ratio, right scale)90 91 92 93 94 95 96 97 98 99 000123456789Fig 1: Short-term Interest Rates in Japan (Call Money Rate)Last data point: Apr-2000%94 95 96 97 98 99 00-7-6-5-4-3-2-10123Fig 2: Bank Lending Growth in Japan, 1994 -2000 Year/Year Percent ChangeApr -