The S&P 500 was trading at 21.2 times earnings on December 31, 1993. On the same day, the dividend yield on the index was 2.74%, and the Treasury bond rate was 6%. The expected growth rate in real GNP was 2.5%.

a. Assuming that the S&P 500 is correctly priced, what is the inflation rate implied in the PE ratio? (Assume stable growth and a 5.5% risk premium.)

b. By February 1994, Treasury bond rates had increased to 7%. If payout ratios and expected growth remain unchanged, what would the effect on the PE ratio be?

c. Does an increase in interest rates always imply lower prices (and PE ratios)?