185 spring 2004

The Fed might raise interest rates someday.

Yesterday, the Federal Open Market Committee backed off a bit on their conviction about not raising short-term interest rates for "a considerable period." We discussed how this caused both stock and bond prices to fall.

Explaining the fall in bond prices was simply a review of our recent calculations plus the introduction of the expectations hypothesis linking long-term interest rates with expected future short-term interest rates.

The decomposition of nominal interest rates into real interest rates plus inflation is also fundamental. This point also leads into our discussion of stock prices.

The key point is that dividends are expected to grow while the paystream from a fixed-income security is, well, fixed.