When inflation expectations rise, interest rates that consumers and businesses pay must rise, at least in the short run, due to the following reasons:
Inflation and interest rates tend to move in the same direction: Higher inflation expectations lead to higher interest rates, and lower inflation expectations lead to lower interest rates. This is because central banks use interest rates as a tool to manage inflation. When inflation expectations rise, central banks may raise interest rates to prevent inflation from rising too quickly.
Nominal interest rates will tend to adjust: When inflation and inflationary expectations change, nominal interest rates will tend to adjust, which may result in shifts in the slope, shape, and level of the yield curve. This is because investors demand higher nominal interest rates to compensate for the expected loss of purchasing power due to inflation.
Investors' fears of inflation: When investors expect higher inflation, they may demand higher interest rates to compensate for the expected loss of purchasing power. This is because higher inflation erodes the value of fixed-income investments, such as bonds.
Consumers and businesses may become more cautious: When inflation expectations rise, consumers and businesses may become more cautious and reduce their spending. This can lead to a slowdown in economic growth, which may prompt central banks to raise interest rates to stimulate the economy.
In summary, when inflation expectations rise, interest rates that consumers and businesses pay must rise, at least in the short run, due to the relationship between inflation and interest rates, the adjustment of nominal interest rates, investors' fears of inflation, and the potential for reduced spending by consumers and businesses.