How would a change in inflationary expectations affect nominal interest
rates and the yield curve?
Yield curves can move up and down and
change shape daily as interest rates change (see July
2004 Ask Dr. Econ). Because
inflationary expectations typically are quickly—although not necessarily
fully—incorporated into the nominal interest rates observed in financial
markets, they are important factors in determining market or nominal
interest rates and shifts in yield curves.
the overall change in the price level, is not a constant, as can be
seen in Chart 1. Over the
past 25 years inflation rates—measured by the Consumer
Price Index (CPI), and the Core
CPI —have varied
dramatically, reaching a peak of around 13 percent in 1980 and falling
below 2 percent at times after 2001. The CPI is a measure of inflation
that the Bureau of Labor Statistics publishes that provides "...monthly
data on changes in the prices paid by urban consumers for a representative
basket of goods and services." The Core
CPI is a measure of inflation that excludes food and energy products
from the CPI. Of course, changes in the inflation rate measured by
these and other inflation indicators often may result in changes in
Interest rates, inflationary expectations, and the real rate of interest
The interest rates your bank pays on deposits or the interest rate yields you see quoted in the newspaper for U.S.
Treasury securities are "nominal interest rates," that
is, unadjusted for inflation. When inflation and inflationary
expectations, or both change, nominal interest rates will tend to adjust,
and may result in shifts in the slope, shape, and level of the yield
curve, as well changes in the estimated real interest rate (see August 2003 Ask Dr. Econ). The real interest
rate is estimated by excluding inflation expectations from the nominal
Thus, a key general relationship to remember about interest rates and
Rate = Estimated Real Interest
Rate + Inflationary Expectations
Of course, nominal interest rates come directly from the financial pages
of your newspaper or the Federal Reserve Board's online Release H.15, Selected
In the paragraphs below, we note several ways to find estimates of future
inflation. With this information, you may estimate a real interest rate,
like the one shown below in Chart 2.
Real interest rates play an important role in the economy because real
interest rates affect the demand for goods and services through borrowing
costs. As is described in U.S.
Monetary Policy: An Introduction (2004), published by the
Federal Reserve Bank of San Francisco, "Changes
in real interest rates affect the public's demand for goods and services
mainly by altering borrowing costs, the availability of bank loans, the
wealth of households, and foreign exchange rates."
Let's put these three series—nominal interest rates, real interest rates,
and inflationary expectations—together and see how they behaved from
1981 to 2004. For nominal interest rates, we will use the 1-year Treasury
bill yield (constant maturity series)—shown as the dashed purple line
in Chart 2. Inflationary expectations for the year ahead come from the
Federal Reserve Bank of Philadelphia's Survey of Professional Forecasters
as the black line in Chart 2. Using these two series, we can calculate
the real or inflation-adjusted returns for each month—the red line in
Chart 2—by subtracting inflationary expectations from the nominal interest
rate. Remember, if the inflation rate (see October
2002 Ask Dr. Econ)
is zero, then nominal interest rates should equal real interest rates.
Estimated real interest rates plotted
in Chart 2 show a lot of variation from 1981 to 2004. From a high of
over 8 percent in 1981, real interest rates trended downward, until
2003 and 2004, when the estimated real rate of interest dropped below
zero. This means nominal interest rates actually fell below the expected
inflation rate. In other words, it looks like a good time to be a borrower!
Inflationary expectations and the yield curve
The 1-year ahead SPF CPI inflation forecasts shown in Chart 2 indicate
a pronounced downward trend in inflationary expectations over the 1981
to 2004 period. Nominal interest rate also trended much lower over the
The downward trend in nominal interest rates and inflation also shows
up in comparisons of yield curves over the period from 1981 to 2003.
Chart 3 presents annual yield curves for six years (1981, 1985, 1990,
1995, 2000, and 2003). The pattern of downward shifts in the yield curves
shown in Chart 3 is consistent with declines in inflationary expectations over
Why should you consider inflation in your financial decisions?
Most economies experience some inflation. Failure
to anticipate future inflation when lending, especially on long-term
securities or loans, can be costly—either in terms of lost interest
or discounted value, or both.
For a simple example of why it is important to anticipate future inflation
when making financial decisions, suppose that in early 2004 you make
a 10-year fixed-interest rate loan to a friend at what looks like a sound
interest rate by today's standards, say a 6 percent annual rate. The
course of inflation over the term of the loan will determine the real
financial benefits of the 6 percent loan. If inflation averages
only 2 percent per year, your real return will average 4 percent. However,
if inflation averages 7 percent per year, your return after inflation
will average -1 percent—your money will actually lose real purchasing
power each year.1 So, it's a
good idea to consider the course of inflation when investing or borrowing
How might you go about estimating inflation, without building a complex
econometric model of the economy like the ones that economic forecasters
use to project future trends for key economic variables like inflation?
Here are a couple of suggestions.
Estimating future inflation: Use the inflation rate
Let's look first at the simplest way to estimate inflation. We'll
start with the Consumer Price
Index (CPI), a widely used measure of inflation in the consumer
sector. The CPI for all items rose 3.0 percent from July 2003 to July 2004. The CPI is shown as the
heavy red line in Chart 1. However, many economists prefer to use an
alternative measure of the CPI, known as the Core CPI. The Core
CPI rose only 1.8 percent over the same period, because the Core CPI
does not include the volatile food and energy components (remember energy
prices rose spiked in 2003 and 2004). As
a result, the Core CPI tends to record a more stable trend in
inflation over time, as can be seen from the thin blue line in Chart
1. The simplest way to estimate of future inflation would be to assume
that the rate of inflation for the past year will continue through the
next year—3.0 percent for the CPI and 1.8 percent for the Core CPI. See
the BLS web site at the beginning of the paragraph for the most recent
CPI data to update your projections.
Estimating future inflation: Ask the economists
A more sophisticated
method would be to use the projections on future inflation estimated
by a group of economic forecasters—like the series
shown in Chart 2. So, check out the FRB
Philadelphia's Economic Research
web site for the SPF inflation expectations. As of the second quarter of 2004, the
short-term SPF inflation forecast for the year ahead was 2.1 percent.
The long-term inflation forecast—the estimated annual average inflation
rate over the next 10 years—generated from the survey was 2.5 percent.
So, at mid-year 2004, the economy was in a period of low inflation combined
with generally low expectations of future inflation.
Chart 4 provides a comparison of the inflationary expectations over
the period from 1981 to 2004 using both the SPF 1-year ahead forecasts
and the current inflation rate measured by the current CPI Index. While
both measures tend to move together, the SPF forecast tends to show less
volatility than the actual CPI.
Price level stability is a key goal of the Federal Reserve so most
forecasts of the economy will discuss the outlook for inflation. Dr. Econ
the monthly FedViews forecast from the Federal
Reserve Bank of San Francisco web site to be a good source for up-to-date
information on inflation trends. FedViews typically
discusses recent inflation measures and contains an up-to-date assessment
of future inflationary trends.
who make payments that are based on nominal interest rates—say an adjustable
rate mortgage or a credit card that is priced based on the prime rate—also
face a risk. In this case the risk is that their nominal loan payments
will rise with inflation
and interest rates.
Blanchard, Oliver. (1997) Macroeconomics, Prentice-Hall, Upper
Saddle River, New Jersey. See Chapter 9.
Consumer Price Index, Bureau of Labor Statistics web site. http://www.bls.gov/cpi/home.htm
FedViews, Federal Reserve Bank of San Francisco web site. http://frbsf.org/publications/economics/fedviews/index.html
Rose, Peter S. (1994) Money and Capital Markets, Irwin, Burr
Ridge, Illinois. See Chapter 9 for additional information on the structure
of interest rates.
Selected Interest Rates (H.15 Release), Federal Reserve Board
of Governors web site. http://www.federalreserve.gov/releases/
Stiglitz, Joseph E., and Carl E. Walsh. (2002) Principles of Macroeconomics.
W.W. Norton & Company, New York. See Chapter 4.
Survey of Professional Forecasters, Federal Reserve
Bank of Philadelphia web site. http://www.phil.frb.org/econ/spf/index.html