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13 To be theoretically precise, we should use a geometric average. Also, because millions of investors are active in the market, it is impossible to determine exactly the consensus expected inflation rate. Survey data are available, however, that give us a reasonably good idea of what investors expect over the next few years. 5 percent. Those expectations led to record-high interest rates. However, the economy cooled in 1981 and 1982, and, as Figure 1-5 showed, actual inflation dropped sharply after 1980.
We discuss the components whose sum makes up the quoted, or nominal, rate on a given security in the following sections. S. Treasury securities in an inflation-free world. The real risk-free rate is not static—it changes over time depending on economic conditions, especially (1) on the rate of return corporations and other borrowers expect to earn on productive assets and (2) on people’s time preferences for current versus future consumption. Borrowers’ expected returns on real asset investments set an upper limit on how much they can afford to pay for borrowed funds, while savers’ time preferences for consumption establish how much consumption they are willing to defer, hence the amount of funds they will lend at different interest rates.
On the other hand, if the market expects inflation to decline in the future, long-term bonds will have a smaller inflation premium than short-term bonds. Finally, if investors consider long-term bonds to be riskier than short-term bonds, the maturity risk premium will increase with maturity. Panel a of Figure 1-7 shows the yield curve when inflation is expected to increase. Here long-term bonds have higher yields for two reasons: (1) Inflation is expected to be higher in the future, and (2) there is a positive maturity risk premium.