Yield Curve Forecasts of Inflation: A Cautionary Tale

by Stephen R. Blough
May/June 1994

Long-term interest rates that are unusually high relative to shortterm interest rates are often seen to reflect market expectations of increasing inflation. Given that the term structure of interest rates (also called the yield curve) reacts to inflation expectations, does it do so in a reasonable manner? Does the term structure embody inflation forecasts that bear a sensible relationship to the iiaflation that in fact occurs?

This article reviews the theoretical link between the term structure and inflation expectations, and then it provides empirical evidence on the link in light of the theory. It finds little evidence of a link between the term structure and future inflation at the horizon chosen for study, the relationship between one- and two-year interest rates and the one-yearahead change in the one-year inflation

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