Investments, tenth edition

15.7 

 The Expectations Hypothesis and Forward Inflation Rates 

 Forward rates derived from conventional bonds are nomi-

nal interest rates. But using price-level-indexed bonds such 

as TIPS, we can also calculate forward  real  interest rates. 

Recall that the difference between the real rate and the 

nominal rate is approximately the expected inflation rate. 

Therefore, comparing real and nominal forward rates 

might give us a glimpse of the market’s expectation of 

future inflation rates. The real versus nominal spread is a 

sort of forward inflation rate. 

 As part of its monetary policy, the Federal Reserve 

Board periodically reduces its target federal funds rate 

in an attempt to stimulate the economy. The following 

page capture from a Bloomberg screen shows the minute-

by-minute spread between the 5-year forward nominal 

interest rate and forward real rate on one day the Fed 

announced such a policy change. The spread immediately 

widened at the announcement, signifying that the market 

expected the more expansionary monetary policy to even-

tually result in a higher inflation rate. The increase in the 

inflation rate implied by the graph is fairly mild, about 

.05%, from about 2.53% to 2.58%, but the impact of the 

announcement is very clear, and the speed of adjustment 

to the announcement was impressive.   

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7/17/13   4:03 PM

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  C H A P T E R  

1 5

  The Term Structure of Interest Rates 

499

 In contrast, under the liquidity preference theory,  f  

2

  would exceed  E ( r  

2

 ).  To  illustrate, 

suppose the liquidity premium is 1%, so  f  

2

  is 6%. Then, for 2-year bonds:

    (1

1 y

2

)

2

5 (1 1 r

1

)(1

1 f

2

)

 

5 1.05 3 1.06 5 1.113  

 implying that 1   1     y  

2

      5  1.055. Similarly, if  f  

3

  also equals 6%, then the yield on 3-year 

bonds would be determined by

    (1

1 y

3

)

3

5 (1 1 r

1

)(1

1 f

2

)(1

1 f

3

)

 

5 1.05 3 1.06 3 1.06 5 1.17978