Inflation, Rates & the Yield Curve

Learning objectives

By the end you can:

1. Define inflation from first principles as a fall in the purchasing power of money (a rise in the general price level), and distinguish it cleanly from the three things beginners confuse it with: disinflation (a falling inflation rate), deflation (a falling price level), and a relative price change in one good.
2. Classify inflation by its engine: demand-pull, cost-push, monetary, and expectations-driven (built-in). State the mechanism of each, give a real example, and explain why the type dictates whether a central bank should fight it or look through it.
3. Explain how inflation is measured and why the choice matters: CPI construction and its four biases; headline versus core and why central banks watch core; the US PCE versus CPI difference (formula, weights, scope) and why the Fed prefers PCE; India's CPI versus WPI and why India moved its anchor from WPI to CPI around 2015. Then read any inflation print as a rate of change, decomposing base effects from genuine momentum.
4. Diagnose the three pathologies: deflation and Irving Fisher's debt-deflation spiral; hyperinflation and its fiscal-monetary mechanism (Weimar, Zimbabwe, Venezuela); and stagflation, why it is the hardest regime to fight, and what the 1970s taught.
5. Argue the Phillips curve evenhandedly: the original inflation–unemployment tradeoff, why it broke down in the 1970s, the expectations-augmented (Friedman–Phelps) version and the vertical long-run curve at the natural rate, and the live modern debate over whether the curve is "flat," "dead," or merely non-linear.
6. Read a yield curve: define the term structure, decompose a long yield into expected future short rates plus a term premium, classify the shape (normal, flat, inverted, humped), and compute and interpret the 2s10s and 10y–3m spreads for both the US Treasury and India G-sec curves.
7. Use the inversion signal and the four curve moves: explain why an inverted curve has led almost every US recession, state the record and the honest caveats (lead time, term-premium distortion, the 2022–24 episode), and classify any curve move as a bull/bear steepener or flattener with its likely driver.
8. Compute duration and cash out "rates as gravity": estimate a bond's price change for a rate move via modified duration, and demonstrate with a worked same-company-two-discount-rates DCF why a higher rate compresses all valuations and hits long-duration assets (growth equities, long bonds, unprofitable tech) hardest. That closes the loop to M3.05's terminal value.

Prerequisites & connections

Builds on. M7.02, where this module begins exactly where the last ended: the policy rate is made there and stretched across time here; the mandate differences (the Fed targets 2% PCE, the RBI targets 4% headline CPI) are stated there and dissected here (§4.5–4.6); and the closing "rate is gravity" idea is proved here (§4.14). M7.01, for the money-and-credit machine and, in particular, the quantity-theory intuition behind monetary inflation (§4.2) and the endogenous-money reason "printing" need not be inflationary. M3.01, time value of money: every claim in the second half of this module is present-value arithmetic; the growing-perpetuity (Gordon) formula and discounting are assumed cold. M3.03, the cost of capital: the risk-free rate that anchors CAPM and WACC is a point on the yield curve, so this module explains where that first input comes from and what moves it. M3.05, terminal value, sensitivity, and reverse DCF: you already computed how sensitive a valuation is to the discount rate; §4.14 supplies the macro cause of that sensitivity and reunites it with duration. M0.03, real versus nominal (Fisher): inflation is the wedge between nominal and real, and the Fisher equation (nominal ≈ real + expected inflation) is the hinge of §4.1 and §4.10.

Feeds forward. M7.04, fiscal policy and sovereign debt: the r versus g debt-dynamics arithmetic runs on the very rate and inflation numbers this module teaches, and hyperinflation (§4.8) is the violent end of the fiscal-dominance story M7.04 formalizes. M7.05, cycles, bubbles, and crises: the yield-curve inversion signal (§4.11) is a leading indicator you will apply to 2008 and 2020, and stagflation (§4.8) is the regime behind the 1970s case study. M7.06, FX and the dollar: real-rate differentials (nominal rate minus expected inflation) are a prime driver of currencies, and the term premium and curve shape reappear in the global bond market. M7.07, the dashboard capstone: the CPI/core-PCE prints, the policy-rate path, the 10y yield, and the 10y–2y and 10y–3m spreads are core dashboard indicators, read exactly as this module teaches: rate-of-change, versus expectations, mapped onto the cycle. And every valuation module downstream inherits §4.14: the discount rate is the gravity, and you now know what moves it.