3. When the expected rate of inflation changes, the expectations for future interest rates also change. An increase in inflation will bring an increase in interest rates, all things being equal. In such a situation, bond prices will go down. If the expected rate of inflation drops, bond prices will increase in anticipation of a potential interest rate cut. The intensity of the price change will depend on the maturity of the bond. Part of the bond's price is determined by its time value, which is the risk of an adverse change in interest rates. Longer bonds have greater interest rate risk, therefore they are subject to more intense changes as a result of changes in the expected inflation rate.
One outcome of this is a change in the yield curve. If inflation is expected to drop, bond prices will increase. This will reduce the yields. Because the long end of the curve has sharper reactions to such changes, it could end up dropping below the front end. This is what is known as an inverted yield curve. It is a predictor of recession because...
Our semester plans gives you unlimited, unrestricted access to our entire library of resources —writing tools, guides, example essays, tutorials, class notes, and more.
Get Started Now