With the sixth interest hike this year, it's been decades since the Federal Reserve has acted this aggressively to slow inflation. Markets reacted strongly to Fed Chair Jay Powell saying rates will be higher than previously expected. Swings tied to interest rates can be hard to understand and it affects people's net worth. Economics correspondent Paul Solman helps break down how investors see it.
Notice: Transcripts are machine and human generated and lightly edited for accuracy. They may contain errors.
Judy Woodruff:
Today's interest rate hike from the Fed was the sixth one this year.
It has been decades since the Fed has acted this aggressively to slow inflation. It's an approach that has been supported by some economists, but is also being criticized as excessive by other economists and by a number of Democratic lawmakers. Markets reacted strongly to the comments by Fed Chairman Jay Powell.
At first, traders and investors were encouraged by a statement suggesting that there could be a pause or a slower pace of rate hikes. But, about a half-hour later, the chairman expanded on that idea.
Jerome Powell, Federal Reserve Chairman:
At some point, as I have said in last two press conferences, it will be appropriate to slow the pace of increases as we approach the level of interest rates that will be significantly restrictive to bring inflation down to our 2 percent goal.
There is significant uncertainty around that level of interest rates. Even so, we still have some ways to go. And incoming data since our last meeting suggests that the ultimate level of interest rates will be higher than previously expected.
Judy Woodruff:
The latter part of those remarks about some ways to go and how the ultimate interest rate level could be higher than previously expected seemed to badly rattle investors.
All the major stock indexes fell significantly afterward, including the Dow Jones industrials, which saw an 800-point negative swing after his remarks. The comments also had a mixed effect on the value of bonds.
These market swings tied to interest rates can be hard to understand, and it affects people's net worth.
Our economics correspondent, Paul Solman, tries to help break down how investors see the impact of higher rates over the long term.
Speaker:
I have taken a hit of $48,000 to my 401(k).
Speaker:
I feel like, basically, when stocks go down, bonds are supposed to go up.
Speaker:
It's kind of like a seesaw. So, you would say, well, one would go up, the other would go down. They would balance each other out. I thought that diversification would be OK.
Paul Solman:
It's been a scary year for those of us counting on our investments, with both stocks and bonds having tanked in tandem. The consensus culprit, inflation and the effort to suppress it.
Simon Johnson, MIT Sloan School of Management: Interest rates are going up. The Fed is attempting to slow inflation.
Paul Solman:
And thus whacking bonds, says economist Simon Johnson, with whom I have gone back and forth over the years trying to explain economics plainly.
So what's a bond?
Simon Johnson:
A bond is a is a form of debt. The way that governments borrow is they say, give us some money now, we will give you money back in the future, and we will pay some interest along the way. And this is in the form of bonds, and you can sell it to other people. It's a tradable debt.
Paul Solman:
So what's happening now that's killing the bond market, making bonds worth less than they were?
Simon Johnson:
There's inflation, and investors need to be compensated for that inflation with a higher interest rate. So, when the government goes to issue debt, which it does on a almost daily basis, it has to offer a higher interest rate.
When you offer a higher interest rate on new debt, people look at old debt, they say, well, I can buy that old debt from you, but I want it to match the yield I can get on the new debt. And the way to match it is for the value of the old debt to fall.
Paul Solman:
Fall like back in the 1970s, when gradual inflation suddenly surged due to a gasoline shortage fueled by OPEC. Interest rates surged in response.
So let's go back in time. I brought with me a facsimile of a bond from 1976, $5,000 bond here, and I have got the 1970s, mid-'70s tie. You have got a 1984 bond, right?
Simon Johnson:
I do. And I have a 1984 tie. The country has swung to the right, so I'm wearing an Adam Smith free market tie.
Paul Solman:
OK, but I bought this, and it was an 8 percent interest rate. So, you have the government, $5,000. It's now 1984. I need the money. So I want to sell this to you. So, give me $5,000.
Simon Johnson:
Well, I appreciate the offer. And I do recognize this is U.S. government debt, and so they're good for the payment.
But I'm a little, I'm afraid, put off by the interest rate, because I have one right here that's offered me 12.25 percent just been issued, brand-new issue. Inflation is higher. Investors need to be compensated for that inflation. So, interest rates have gone up.
So, I will buy your bond, the old bond, from you, but for less than $5,000. I'm fine with that.
Paul Solman:
This is why, when interest rates go up, back in the '70s and '80s, now, bond values, the bond market goes down.
Simon Johnson:
Yes.
The way to think about it is that the interest rate being offered on new bonds is higher than on the old bonds. So you need the yield to match in order for people to be willing to buy the old bonds. Otherwise, they're just going to stick with the new bonds. For that to happen, the price of the old bonds have to go down.
Paul Solman:
OK, but that doesn't explain why stocks also sank as interest rates rose.
Robert Merton won a Nobel Prize for his work in finance
Robert Merton, MIT Sloan School of Management: The king of Sweden gives you the gold medal in a case.
Paul Solman:
He's been teaching about stocks for decades.
Robert Merton:
Here's the share of stock. And why does it have value? It has value because you have rights to the current future earnings for the firm.
Paul Solman:
Why are stocks going down now?
Robert Merton:
To understand stocks, you have to understand the three elements that enter into their value or their change in value?
First, it's the earnings. Everything else the same, the higher those earnings, the more valuable. A second factor that affects value is, are the earnings going to grow from here? That would be good, makes it even more valuable. Or are they going to decline or stay flat? Makes it less valuable.
Paul Solman:
But you said there was a third factor.
Robert Merton:
The future earnings on stock are risky, unknown.
The future payments on bonds are known. To compensate people for taking the risk of uncertainty about the future earnings of the stock, they have to be compensated with a higher expected yield or return than on bonds.
Paul Solman:
I ask you, why have stock price has been going down? You say to me?
Robert Merton:
Concerns over possible recessions in the future. We know that the Fed is purposely trying to raise interest rates to cool the economy down. So we know there's a greater chance that we might have a recession, which means lower earnings, and competing rates, greater uncertainty, the impact of inflation, all those things.
You put it together, it's not a surprise, but the question is, what will they do tomorrow? It depends on what new information we have compared to what we know today.
Paul Solman:
So there is no simple answer to stocks are going to continue to go up, continue to go down? Even you can't give me an answer.
Robert Merton:
No, you can't do it and give a 30-second sound bite answer to, why is the stock market going to go up or down tomorrow? Tell us the reason, when there are multiple reasons. It's too complicated. I wish I could tell you other words, but that's just life.
Paul Solman:
I wish he could too, especially to someone who so often relies on 30-second sound bites.
For the "PBS NewsHour," Paul Solman in Boston.
