hi guys,
in schweser notes book 2:
on asset allocation, p.193 and 194:
the question says:
“The portfolio manager expects the central bank to loosen monetary policy, resulting in a small reduction in real interest rates and a large increase in inflation expectations.”
and then the answer says:
“The small fall in real rates and large increase in inflation expectations will raise interest rates and reduce bond prices and returns.”
i am not sure why a loose monetary policy would lead to an increase in interest rates. shouldnt it be decline in interest rates?
i dont get why it is "small fall in real rates and large increase in inflation expectations."
please share, thanks so much.
Let’s assume that the central bank executes monetary policy through opwn market operations (to have a concrete example). Their policy is expansionary, so they’re buying short-term bonds. Here’s what happens:
- Short-term bond prices go up: more demand
- Short-term interest rates go down: prices up, yields down
- More money is in circulation: buying bonds expands the money supply
- Inflation increases: more money available to buy the same goods will drive prices up (demand pull inflation)
Voilà!
(Note: you won’t necessarily get a small reduction in real rates and a large increase in inflation; the magnitudes could vary. But it’s not out of the question that they could be small and large, respectively.)