Question

If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market’s predictions for the inflation rate in the future?

Short answer

The yield of a bond, interest rate, and inflation rate always move together in the same direction. It implies that whenever the inflation rate rises, the interest rate also rises consequently.

Step-by-step solution

Step 1:Definition

The yield curve shows the different interest rates of bonds with equal credit quality but different maturity dates.

Explanation

Both the interest rates and the expected inflation rates are moved together. But, both of these two inflation rate and interest rates on bond moves in the opposite direction with the bond price. Since in this case it is found that the expected interest rate is going to rise in the future, so expected inflation rate also will rise. The yield curve recommends that the market assumes that inflation declines moderately in the upcoming future but increases in the later period.