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

In the future as the interest rate rises, the expected inflation rate also may rise, and eventually, as the interest rate falls, the inflation rate is also expected to fall.

Step-by-step solution

Definition

Yield to maturity (YTM) is the total rate of return earned by a bond after it has made all interest payments and repaid the original principal.

Explanation

In the figure above, the yield curve initially moves upward and after a while starts falling down. The upward trend of the yield curve indicates that the predicted short-term interest rate will climb moderately in the near future. Also, the next downward section of this curve implies that in the future the short-term interest rate is expected to fall sharply.

We know that the interest rate and inflation rate move together in the same direction. As a result, in the near future, as the interest rate rises, the expected inflation rate also may rise. After some time as the interest rate falls, the inflation rate is also expected to fall.