- dated maturities. to begin our discussion of the yield curve, it is worth revisiting the fisher equation, named after american economist irving fisher. the textbook equation states that nominal interest rates are equal to the required real rate of return on the funds invested, plus the expected inflation rate over the period of the investment. so it is clear that expected inflation plays an important role. the fisher equation can be modified to include a risk margin in the calculation of the nominal interest rate. the risk margin can reflect variability in the inflation rate ; it will in practice also take account of factors such as political and exchange rate risk. what will happen to capital market interest rates if investors decide they have to revise their expectations of future inflation upwards? investors in long - term assets who believe future inflation will be higher than initially expected will want to protect their real returns. as a result, they will demand higher nominal interest rates on longer - term bonds. in such a situation, one would expect the yield curve to steepen. can we say that if the yield curve steepens, it should necessarily be taken as a sign that the expected inflation rate in the future has risen? the answer to that is clearly no ; expected inflation is only one factor determining nominal interest rates. an increase in expected inflation should lead to a steepening in the yield curve, but - and this is a crucial point - a steeper yield curve does not necessarily signal a rise in expected inflation. the effect on the yield curve of factors other than expected inflation the yield curve is normally positively sloped ; in other words, the longer the duration of the investment, the higher the yields. the positive slope is explained, among others, by the premium on long - term bonds which is required to compensate for the greater risk in keeping paper with longer maturities. so, a positively sloping yield curve does not in itself tell us anything about inflation expectations or the economy. a crucial point in an analysis of the shape of the yield curve is that long bond yields are entirely market - determined while short - term interest rates are influenced by the monetary policy decisions of the central bank - which should, of course, also respect market forces. it follows that a steepening in the yield curve can be caused by monetary easing. such a steepening will happen when a reduction in short - term interest rates is not accompanied by a commensurate decline in long bond yields. why would long bond yields not follow short - term interest rates lower to the

portfolios, i shall discuss an issue which appears to be something of a favourite topic among south africa ’ s investment analysts - the term structure of interest rates, or the yield curve. the market determines different yields on investments of different maturities ; of considerable importance is the gap between interest rates on short - dated investments and those with longer maturities. if these interest rates are plotted against unexpired maturity, the result is the yield curve, and of importance is its slope. does the slope of the yield curve provide the reserve bank and the investment community with useful information? before discussing the issue, it is worth noting that there are many good reasons to take into account signals from the financial markets in reaching monetary policy decisions. for one thing, market prices are up to date, and policymakers therefore do not face the problem that they do with other economic data. information on the real economy only becomes available after a time lag, and it is possible that by the time enough information has been acquired on, say, trends in capacity utilisation or unit labour costs to make it clear what course of action is necessary, it might be very late in the day. in addition, it seems that some indicators that are relatively current, such as the monetary aggregates, are not sufficient by themselves as early - warning signals of inflation. the most obvious way in which the yield curve can assist the reserve bank is in providing information on inflation expectations. but, as i shall argue, the message from the yield curve is not unambiguous in this respect. i shall discuss the issue in general terms first, before mentioning recent developments in the south african capital market and the issues raised by some of the local investment analysts. the yield curve and inflation expectations one of the greatest difficulties which all central banks face is getting a reliable measure of inflation expectations. difficult though it is, it is nonetheless important to try to monitor inflation expectations, as they play an important role in price and wage setting behaviour. one way of monitoring inflationary expectations is to conduct a survey among the public ( which the reserve bank intends to do ) ; another way would be to monitor the behaviour of market - determined interest rates, or the yield curve. as you know, the yield curve is upward sloping, or positive, when nominal interest rates on longer - dated bonds are higher than those on shorter - dated securities. it can also be downward sloping, or inverted, if the short - term interest rates exceed the rates on bonds with long