Due to a recession, expected inflation this year is only 3.25%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 3.25%.
Assume that the expectations theory holds and the real risk-free rate (r ) is 2.5%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 1.5%, what inflation rate is expected after Year 1?