In 2004, inflation had picked up and had raised questions in the minds of some people about whether it might be on a rising trend that poses a risk to price stability. Total consumer price inflation as measured by the chain price index for personal consumption expenditures (PCE) has risen from 1.4 percent over the twelve months of last year to an annual rate of 3.0 percent over the first four months of 2004.
The situation is quite similar in recent month due to the increase in the oil price and the Katrina storms. According to BBC News (2005), the two factors have driven the increase in retail prices by 1.1%, excluding car sales, partly as a result of the dramatic increase in the oil price.
Donald L. Kohn, a Governor of the Federal Reserve, says that price stability is Fed’s responsibility since it allow businesses and households to plan and operate without worrying about increases in the general price level over the long run is how we contribute best to fostering economic efficiency and rising standards of living (“Remarks”).
Inflation has closed relationship with interest rates. In the situation where retail prices experience a significant increase, people might expect that interest rate will rise as well. The reason is that government try to control the amount of money exist in the market.
According BBC News (2005), the increase of oil price and Katrina storm have caused investors in Wall Street to think of Federal Reserve that will likely to push up interest rates rapidly to control inflation.
In the United States, the Treasury yield curve is the first indicator of all domestic interest rates and it influence global rates setting. Therefore, in the U.S., interest rates on all other domestic bond categories rise and fall with Treasuries yield. Below is the figure explaining the impact of inflation and interest rates on the Yield.
Figure 1 Relationship between Inflation, Interest Rates and Yield
Source: BBC News. (2005). Energy prices stoke US inflation. Retrieved October 30, 2005 fromhttp://news.bbc.co.uk/2/hi/business/4342456.stm
Traditionally, the slope of the U.S. Treasury yield curve, whether a steep or a flat one, becomes important indicator of economic activity. This is due to the fact that the curve gives indication about what interest rates could be in the future (“Bond Basic”).
In case of investment, investors demand that Investors demand more yield as bond maturity extends (as shown in the figure). The reason is that investors hope that the increasing returns will beat higher inflation and higher interest rates. In case that inflation is rising, the Federal Reserve will likely to raise interest rates to fight inflation.
BBC News. (2005). Energy prices stoke US inflation. Retrieved October 30, 2005 fromhttp://news.bbc.co.uk/2/hi/business/4342456.stm
“Bond Basics.” September 2004. Retrieved November 10, 2005 from http://www.pimco.com/LeftNav/Bond+Basics/2004/Yield_Curve_Basics.htm
Estrella, Arturo. Why Do Interest Rates Predict Macro Outcomes? A Unified Theory of Inflation, Output, Interest, and Policy. Retrieved October 30, 2005 fromhttp://www.newyorkfed.org/research/staff_reports/research_papers/9717.html
Harper, David. Trying To Predict Interest Rates. 2003. Retrieved October 30, 2005 from http://www.investopedia.com/articles/03/122203.asp
Introduction to Economy. Retrieved October 30, 2005 from http://www.investorguide.com/igueconintro.html
Remarks by Governor Donald L. Kohn. (2004). Retrieved October 30, 2005 from http://www.federalreserve.gov/boarddocs/speeches/2004/20040604/default.htm