Question

Illustrate with numerical examples of how future inflation impacts the yield curve.

Answer 1

Future inflations are impacting the yield curve because when there would be a higher inflation in the economy it would be impacting the overall interest rate in the economy to large extent, because there would be a higher future inflation, it would mean that the economy is generating enough amount of demand and it would mean that there would be an increase in the interest rate and there would be an increase in the long term interest rate more than the short term interest rates, so there would be an upward sloping yield curve. when there would be expectation of rising interest rate into the economy , rising interest rate is often interpreted that Federal Reserve will be increasing the interest rates when there will be increased inflation in the economy so it would be resulting into upward sloping yield curve.

When there is an expectation of future inflation going down and it would be impacting the long-term Interest rates more than the short terms Yield curve and there would be an expectation of downward yield curve because there would be lowering of the interest rate in order to deal with the lower demand in the economy and lower inflation in the economy so it would be resulting into a downward sloping in the curve.

For example, if the future expectation of inflation has been around 5% and the future expectation of the interest rate would also be around 5%, because there would be a synchronisation of both inflation and interest rate in order to provide with the loss of time value of money as well, so,it can be easily interpreted that interest rate will be increased in order to cut down the effect of inflation so it would be resulting into a downward sloping yield curve.