Primer: Inflation Swaps

An inflation swap is a derivative contract that corresponds to breakeven inflation. The advantage of an inflation swap for analysis is that it does give a pure read on an economic breakeven inflation rate, as the contract literally implies an economic inflation breakeven. The problem with the inflation swap market – at least when I was working in fixed income – was the limited liquidity for the contracts. In addition, it does not represent a cash investment, and so is not accessible to some investors, while for others, it does not fit into how they view portfolio construction.

This article is an unedited excerpt of my upcoming book on inflation breakeven analysis. There are numerous references to other sections of the book, which I have left in place. The book is largely completed, but I am holding off publication until August or September.

Money Demand Has Very Little To Do With Recessions

One often encounters assertions that recessions are the result of an excess demand for money (or some variant), based on various equilibrium arguments. Although one could superficially interpret recessions in such a fashion, the issue is that this interpretation does not help analyse the business cycle. In other words, it is a non-falsifiable statement that offers no useful information. In my view, discussions involving "money" or "safe assets" provide us an example regarding the limited usefulness of mainstream economic theory for business cycle analysis.

Interview Coming Up

UPDATE: Technical problems forced a reschedule of the interview.

I will be taking part an interview tomorrow; I will pass along details as they come in.

Otherwise, I was being a prototypical Canadian and helping paint my curling club for most of the past week. Other than the interview details, I will not be publishing anything until the weekend.

Understanding Why The Supply Of Inflation-Linked Bonds Is Limited

One of the key economic problems facing inflation-linked markets is that central governments tend to be the major source of net supply of these bonds. This is very much unlike the case for conventional bonds, where non-central government supply is significant. If there is a shortage of private sector duration, it is in the 30-year part of the curve, as the credit analysis of such debt is tricky for most issuers. (Utilities and similar would be the most natural fit, but as the telecom industry showed, even apparently stable business models can be greatly disrupted by new technology, or by CEO’s with grandiose schemes.)

This article is an unedited excerpt from my upcoming book "Inflation Breakeven Analysis." The book is essentially completed; I am just giving it a last read before passing it on to an editor.  

Understanding Why Governments Cannot Use Stock Prices As A Policy Tool

Professor Roger E. Farmer proposed in his book Prosperity for All (link to my review) that  governments should set up a body to control equity prices as a means to smooth the economic cycle. In this article, I explain why a government could not hope to control the level of stock prices in a meaningful sense.

(This was a discussion that I deferred from my review. I expect to write a final article that explains why that even if the stock market could be controlled, it would not be useful for policy purposes.)

Of course, it might be possible for a government with a large sovereign wealth fund to influence the stock market. However, unless it could convince other investors that it was investing in fashion designed to provide strong returns, other investors would probably ignore the government's attempt to jawbone stock prices. If it wants to engage in economic stabilisation, there is no reason to follow the government's preferences.

On The Primacy Of The Inflation Target

Neil Macdonald recently wrote the article "The Bank of Canada wields enormous power, yet decisions are made in relative secrecy," which questioned the Bank of Canada's secrecy, and its mandate. The article itself is somewhat curious, but it was written in response to a letter by 61 economists. The points raised by that letter appear to be more interesting. Given that I do not attach great potency to monetary policy, I am not particularly concerned about current arrangements. Even if the New Keynesians are misguided in their analysis of the economy, they cannot do a great deal of damage with interest rate policy.

My comments are directed at the Canadian situation, but could be applied to other some developed countries with some modifications. In particular, the European Central Bank faces quite different issues.

Book Review: Prosperity For All

Professor Roger E. A. Farmer has written Prosperity For All: How to Prevent Financial Crises, in which he lays out the case for creating a sovereign wealth fund whose objective is to stabilise financial markets. If we can eliminate financial crises, we can avoid the rise in unemployment that results. Although that is an interesting concept, I was highly skeptical about the idea before I read the book -- and my skepticism remains after reading it. Instead, the discussion of macro theory within the book is why it is of interest.