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12 06 2015 | by Victor Xing | Capital Markets

The relationship of inflation expectations vs. rates

Changing realized inflation and projected path of future inflation (inflation expectations) affect interest rates through the central bank expectations channel (which largely impacts front-end and belly part of the yield curve) and inflation risk premium channel (mainly impacts long-end of the curve):
  1. If inflation rises more rapidly than expected, investors would expect the central bank to raise rates sooner (timing) over the near term and more rapidly (pace) over the medium term.  Assuming the central bank has a strong inflation fighting credential, market participants will likely do the following:
    1. Short front-end rates (expectation of sooner policy tightening) as well as 3 to 5 year rates (more hikes in the future)
    2. Neutral or even long intermediate and long-term rates to reflect expectations that policy tightening would achieve the goal of bring down long-term inflation
  2. Higher inflation is beneficial to borrowers (issuers of bonds), such that debt payment in nominal terms would be cheaper to repay in the future than the present.  On the other hand, lenders (buyers or investors of the bonds) will be “locked” into fixed income that declines in purchasing power.  As a result, investors would demand long-term debt issuers to sell bonds at higher yields to compensate investors for inflation risk – this is also known as inflation risk premium
Therefore, investors act as agents to transmit changing policy expectations and changing inflation risk premiums into the real economy by adjusting their risk exposures across the yield curve.
inflation expectations
Inflation (measured in CPI) vs. federal funds rate and 5 year Treasury rate


Original Quora article

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