Aurora Borealis
1 November 1982 Financial Analysts Journal Volume 38, Issue 6

The Yield Curve and Expected Inflation

  1. Haim Levy

In the absence of inflation, the yield curve for government bonds simply describes the before-tax, default-free real interest rate for various maturities. It should thus be possible to take the yield curve from a period of zero, or very low, inflation as a proxy for the real yield curve and to compare it with yield curves observed during periods of high inflation in order to obtain an estimate of future inflation rates as predicted by the market. Comparing the nominal yield curve observed in 1980 with the real yield curve as estimated from 1961-64 data gives us expected inflation rates for the years 1980 to 1985 of 11.9, 10.34, 9.46, 8.31 and 8.89 per cent, respectively.

Adjusting real and nominal yield curves for taxes on capital gains and interest income reduces the estimates of expected inflation. This is because coupon rates, which are generally low in periods of little or no inflation, tend to rise during periods of high inflation, and interest income to investors is taxed at a high rate. Pretax nominal yields during periods of high inflation thus reflect future inflation and higher taxation.

Expected inflation rates derived from comparing nominal yield curves from 1965 to 1980 with the real yield curve were compared with actual inflation rates over the period. The results indicate that the estimates were not significantly different from actual inflation values when inflation was moderate. They were significantly lower than actual inflation rates, however, when annual inflation rates reached six per cent or more. It appears that, in periods of high inflation, investors jointly predict future inflation and a decline in the real interest rate.

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