A 21st century gold standard

Imagine waking up in the morning and checking the hockey scores, news, the weather, and how much the central bank has adjusted the gold content of the dollar overnight. This is what a 21st century gold standard would look like.

Central banks that have operated old fashioned gold standards don't modify the gold price. Rather, they maintain a gold window through which they redeem a constant amount of central bank notes and deposits with gold, say $1200 per ounce of gold, or equivalently $1 with 0.36 grains. And that price stays fixed forever.

Because gold is a volatile commodity, linking a nation's unit of account to it can be hazardous. When a mine unexpectedly shuts down in some remote part of the world, the necessary price adjustments to accommodate the sudden shortage must be born by all those economies that use a gold-based unit of account in the form of deflation. Alternatively, if a new technology for mining gold is discovered, the reduction in the real price of gold is felt by gold-based economies via inflation.

Here's a modern fix that still includes gold. Rather than redeeming dollar bills and deposits with a permanently fixed quantity of gold, a central bank redeems dollars with whatever amount of gold approximates a fixed basket of consumer goods. This means that your dollar might be exchangeable for 0.34 grains one day at the gold window, or 0.41 the next. Regardless, it will always purchase the same consumer basket.

Under a variable gold dollar scheme the shuttering of a large gold mine won't have any effect on the general price level. As the price of gold begins to skyrocket, consumer prices--the reciprocal of a gold-linked dollar--will start to plummet. The central bank offsets this shock by simply redefining the dollar to contain less gold grains than before. With each grain in the dollar more valuable but the dollar containing fewer grains of the yellow metal, the dollar's intrinsic value remains constant. This shelters the general price level from deflation.

This was Irving Fisher's 1911 compensated dollar plan  (see chapter 13 of the Purchasing Power of Money), the idea being to 'compensate' for changes in gold's purchasing power by modifying the gold content of the dollar. A 1% increase in consumer prices was to be counterbalanced by a ~1% increase in the number of gold grains the dollar, and vice versa. Fisher referred to this fluctuating definition as the 'virtual dollar':

From A Compensated Dollar, 1913

Fisher acknowledged that 'embarrassing' speculation was one of the faults of the system. Say the government's consumer price report is to be published tomorrow and everyone knows ahead of time that the number will show that prices are rising too slow. And therefore, the public expects that the central bank will have to increase its gold buying price tomorrow, or, put differently, devalue the virtual dollar so it is worth fewer ounces of gold. As such, everyone will rush to exchange dollars for gold at the gold window ahead of the announcement and sell back the gold tomorrow at the higher price. The central bank becomes a patsy.

Fisher's suggested fix  was to introduce transaction costs, namely by setting a wide difference between the price at which the central bank bought and sold gold. This would make it too expensive buy gold one day and sell it the next. This wasn't a perfect fix because if the price of gold had to be adjusted by a large margin the next day in order to keep prices even, say because a financial crisis had hit, then even with transaction costs it would still be profitable to game the system.

A more modern fix would be to adjust the gold content of the virtual dollar in real-time in order to remove the window of opportunity for profitable speculation. Given that consumer prices are not reported in real-time, how can the central bank arrive at the proper real-time gold price? David Glasner once suggested targeting the expectation. Rather than aiming at an inflation target, the central bank targets a real-time market-based indicator of inflation expectations, say the TIPS spread. So if inflation expectations rise above a target of 2% for a few moments, a central bank algorithm rapidly reduces its gold buying price until expectations fall back to target. Conversely, if expectations suddenly dip below target, over the next few seconds the algorithm will quickly ratchet down the content of gold in the dollar to whatever quantity is sufficient to restore the target (i.e. it increases the price of gold).

Gold purists will complain that this is a gold standard in name only. And they wouldn't be entirely wrong. Instead of defining the dollar in terms of gold, a compensated dollar scheme could just as well define it as a varying quantity of S&P 500 ETF units, euros, 10-year Treasury bonds, or any other asset. No matter what instrument is being used, the principles of the system would be the same.

A compensated dollar scheme isn't just a historical curiosity; it may have some relevance in our current low-interest rate environment. Lars Christensen and Nick Rowe have pointed out that one advantage of Fisher's plan is that it isn't plagued by the zero lower bound problem. Our current system depends on an interest rate as its main tool for controlling prices. But once the interest rate that a central bank pays on deposits has fallen below 0%, the public begins to convert all negative-yielding deposits into 0% yielding cash. At this point, any further attempt to fight a deflation with rate cuts is not possible. The central banker's ability to regulate the purchasing power of money has broken down.*

Under a Fisher scheme the tool that is used to control purchasing power is the price of gold, or the gold content of the virtual dollar, not an interest rate. And since the price of gold can rise or fall forever (or alternatively, a dollars gold content can always grow or fall), the scheme never loses its potency.

Ok, that is not entirely correct. In the same way that our modern system can be crippled under a certain set of circumstances (negative rates and a run into cash), a Fisherian compensated dollar plan had its own Achilles heel. If gold coins circulate along with paper money and deposits, then every time the central bank reduces the gold content of the virtual dollar in order to offset deflation it will have to simultaneously call in and remint every coin in circulation in order to keep the gold content of the coinage in line with notes and deposits. This series of recoinages would be a hugely inconvenient and expensive.

If the central bank puts off the necessary recoinage, a compensated dollar scheme can get downright dangerous. Say that consumer prices are falling too fast (i.e. the dollar is getting too valuable) such that the central banker has to compensate by reducing the gold content of the virtual dollar from 0.36 grains to 0.18 grains (I only choose such a large drop because it is convenient to do the math). Put differently, it needs to double the gold price to $2800/oz from $1400. Since the central bank chooses to avoid a recoinage, circulating gold coins still contain 0.36 grains.

The public will start to engage in an arbitrage trade at the expense of the central bank that goes like this: melt down a coin with 0.36 grains and bring the gold bullion to the central bank to have it minted into two coins, each with 0.36 grains (remember, the central bank promises to turn 0.18 grains into a dollar, whether that be a dollar bill, a dollar deposit, or a dollar coin, and vice versa). Next, melt down those two coins and take the resulting 0.72 grains to the mint to be turned into four coins. An individual now owns 1.44 grains, each coin with 0.36 grains. Wash and repeat. To combat this gaming of the system the government will declare the melting-down of  coin illegal, but preventing people from running garage-based smelters would be pretty much impossible. The inevitable conclusion is that the public increases their stash of gold exponentially until the central bank goes bankrupt.

This means that a central bank on a compensated dollar that issues gold coins along with notes/deposits will never be able to fight off a deflation. After all, if it follows its rule and reduces the gold content of the virtual dollar below the coin lower bound, or the number of grains of gold in coin, the central bank implodes. This is the same sort of deflationary impotence that a modern rate-setting central bank faces in the context of the zero lower bound to interest rates.

In our modern system, one way to get rid of the zero lower bound is to ban cash, or at least stop printing it. Likewise, in Fisher's system, getting rid of gold coins (or at least closing the mint and letting existing coin stay in circulation) would remove the coin lower bound and restore the potency of a central bank. Fisher himself was amenable to the idea of removing coins altogether. In today's world, the drawbacks of a compensated dollar plan are less salient as gold coins have by-and-large given way to notes and small base metal tokens.

In addition to evading the lower bound problem, a compensated dollar plan would also be better than a string of perpetually useless quantitative easing programs. The problem with quantitative easing is that commitments to purchase, while substantial in size, are not made at any particular price, and therefore private investors can easily trade against the purchases and nullify their effect. The result is that the market price of assets purchased will be pretty much the same whether QE is implemented or not. Engaging in QE is sort of like trying to change the direction of the wind by waving a flag, or, as Miles Kimball once said, moving the economy with a giant fan. A compensated dollar plan directly modifies the price of gold, or, alternatively, the gold content of the dollar, and therefore has an immediate and unambiguous effect on purchasing power. If central bankers adopted Fisher's plan, no one would ever accuse them of powerlessness again.

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*Technically, interest rates need never lose their potency if Miles Kimball's crawling peg plan is adopted. See here.

Liquidity as static

In his first blog skirmish, Ben Bernanke took on Larry Summers' secular stagnation thesis, generating a slew of commentary by other bloggers. If the economy is in stagnation, the econ-blogosphere surely isn't.

I thought that Stephen Williamson had a good meta-criticism of the entire debate. Both Bernanke and Summers present the incredibly low yields on Treasury inflation protected securities (TIPS) as evidence of paltry real returns on capital. But as Williamson points out, their chosen signal is beset by static.

Government debt instruments like TIPS are useful as media of exchange, specifically as collateral, goes Williamson's argument. Those who own these instruments therefore enjoy a stream of liquidity services that gets embodied in their price as a liquidity premium. Rising TIPS prices (and falling yields) could therefore be entirely unrelated to returns on capital and wholly a function of widening liquidity premia. Bernanke and Summers can't make broad assumptions about returns on capital on the basis of market-driven yields without knowing something about these invisible premia. (Assiduous readers may remember that I've used a version of the liquidity premium argument to try to explain the three decade long bond bull market, as well as the odd twin bull markets in bond and equity prices.)

Riffing on Williamson, liquidity premia are a universal form of static that muddy not only bond rates but many of the supposedly clear signals we get from market prices. Equity investors, for instance, need to be careful about using price earnings ratios to infer anything about stock market valuations. The operating assumption behind something like Robert Shiller's cyclically adjusted PE (CAPE) measure is that rational investors apply a consistent multiple to stock earnings over time. When CAPE travels out of its historical average, investors are getting silly and stocks are over- or undervalued.

But not so fast. Since a stock's price embodies a varying liquidity premium, a rise in equity prices relative to earnings may be a function of changes in liquidity premia, not investor irrationality. Until we can independently price these liquidity services, CAPE is useless as a signal of over- or undervaluation, a point I've made before. Hush, all you Shiller CAPE acolytes.

Liquidity also interferes with another signal dear to economists and finance types alike; expectations surrounding future inflation. The most popular measure of inflation expectations is distilled by subtracting the nominal yield on 10-year Treasuries from the equivalent yield on 10-year TIPS. The residual is supposed to represent the value of inflation protection offered by TIPS. But it is a widely known fact that this measure is corrupted by the inferior liquidity in TIPS markets. See commentary here, here, and here. The upshot is that a widening in TIPS spreads—which is widely assumed to be an indicator of rising inflation expectations—could be due to a degeneration  improvement in the liquidity of TIPS relative to the liquidity of straight Treasuries.

Interestingly, the Cleveland Fed publishes a measure of inflation expectations that tries to "address the shortcomings" of rates derived from TIPS by turning to data from a different source: inflation swaps markets. In an inflation swap, one party pays the other a fixed rate on a nominal amount of cash while the other returns a floating rate linked to the CPI. Given the market price of this swap, we can extract the market's prediction for inflation. According to the people who compile the Cleveland Fed estimate, inflation swaps are less prone to changes in liquidity than TIPS yields, thus providing a true signal of inflation expectations.

But how can that be? Surely the prices of swaps and other derivatives are not established independently of market liquidity. After all, like stocks and bonds, derivatives are characterized by bid-ask spreads, buyers strikes, and runs. Sometimes they are easy to buy or sell, sometimes difficult. When I first thought about this, it wasn't immediately apparent to me what liquidity premia in derivative markets would look like. With bond and equity markets, its easy to determine the shape and direction of the premium. Since liquidity is valuable, buyers compete to own liquid stocks and bonds while sellers must be compensated for doing without them. A premium on top of a security's fundamental value develops to balance the market.

Derivatives are different. Take a call option, where the writer of the option, the seller, provides the purchaser of the option the right to buy some underlying security at a certain price. In theory, the more liquid the option, the higher the price the purchaser should be willing to pay for the option. After all, a liquid option can be sold much easier than an illiquid one, a benefit to the owner. But what about the seller? I risk repeating myself here, but a seller of a stock or bond will require a *higher* price if they are to part with a more liquid the security. However, in the case of the option, the writer (or seller) will be willing to accept a *lower* and inferior price on a liquid option. After all, the writer will face more difficulties backing out of their commitment (by re-selling the option) if it is illiquid than if it is liquid.

This creates a pricing conundrum. As liquidity improves, the option writer will be willing to sell for less and the purchaser willing to buy for more. Put differently, the value that the writer attributes to the option's liquidity and the concomitant liquidity premium this creates drives the option price down, while the value the purchaser attributes to that same liquidity engenders a liquidity premium that drives the option price up. What is the net effect?

I stumbled on a paper which provides an answer of sorts (pdf | RePEc). Drawing on data from OTC options markets, the authors finds that illiquid interest rate options trade at higher prices relative to more liquid options. This effect goes in the opposite direction to what is observed for stocks and bonds, where richer liquidity means a higher price. The authors' hypothesis is that the liquidity premium of an option is set by those investors who, on the margin, are most concerned over liquidity. Given the peculiarities of OTC option markets, this marginal investor will usually be the option writer (or seller), typically a dealer who is interested in reversing their trades and holding as little inventory as possible, thus instilling a preference for liquidity. Buyers, on the other hand, tend to be corporations who are willing to buy and hold for the long term and are therefore less concerned with a fast getaway. The net result is that for otherwise identical call options, the overriding urgency of dealers drives the price of the more liquid option down and illiquid one up.

Anyone who has dabbled in futures markets may see the similarity in the story just recounted to a much older idea, the theory of normal backwardation. The intuition behind normal backwardation is that a futures contract, much like a call option, has two counterparties, both of whom need to be rewarded with a decent expected return in order to encourage them to enter into what is otherwise a very risky bet. If both require this return, then how does an appropriate "risk premium" get embodied in a single futures price?

None other than John Maynard Keynes hypothesized that the two counterparties to a futures trade are not entirely symmetrical. Hedgers, say farmers (who are normally short futures), simply want a guaranteed market for their goods come harvest and are willing to provide speculators with the extra return necessary to induce them to enter into a long futures position. Farmers create this inducement by setting the current price of a futures contract a little bit below the expected spot price upon delivery, thus providing speculators with a promise of extra capital returns, or a risk premium. That's why Keynes said that futures markets are normally backwardated.

Options writers who desire the comforts of liquidity are playing the same game as farmers who desire a guaranteed price. They are inducing counterparties to take the other side of the deal, in this case the liquid one, by pricing liquid options more advantageously than illiquid but otherwise identical options. And while I don't know the peculiarities of the various counterparties to an inflation swap, I don't see why the same logic that applies to options wouldn't apply to swaps.

So returning to the main thread of this post, just as the signals given off by TIPS spreads are beset by interference arising from liquidity phenomena, the signals given off by inflation swaps are also corrupted. A widening in inflation swap spreads could be due to changing liquidity preference among a certain class of swap counterparties, not to any underlying change in inflation expectations. Its not a clear cut world.

What about the most holy of signals given off by derivative markets: the odds of default as implied by credit default swap spreads? A CDS is supposed to indicate the pure credit risk premium on an underlying security. But if the marginal counterparty on one side of a credit default swap deal is typically more interested in liquidity than the other counterparty, then CDS prices will include a liquidity component. According to the paper behind the following links ( pdf | RePEc ), it is the sellers of credit default swaps, not the buyers, who typically earn compensation for liquidity, the theory being that sellers are long-term players with more wealth than buyers. The paper's conclusion is that CDS spreads cannot be used as frictionless measures of default risk.

Liquidity is like static, it blurs the picture. The clarity of the indicators mentioned in this post—Bernanke & Summers' real interest rates, stock market price earnings ratios, inflation expectations implied by both TIPS and swap markets, and finally the odds of default implied in corporate default swap spreads—are all contaminated by liquidity premia that vary in size over time. Models created by both economists and financial analysts contain abstract variables that map to these external data sources. I doubt that this data is irrevocably damaged by liquidity, but it may be warped enough that we should be wary about drawing strong conclusions from models that depend on them as input.

Before I slide too far into economic nihilism, there may be a way to resuscitate the purity of these indicators. If we can calculate the precise size of liquidity premia in the various markets mentioned above, then we can clean up the real signals these markets give off by removing the liquidity static.

One way to go about calculating the size of a liquidity premium is by polling the owners of a given security how much they must be compensated for doing without the benefits of that security's liquidity for a period of time. Symmetrically, a potential owner of that security's liquidity is queried to determine how much they are willing to pay to own those services. The price at which these two meet represents the pure liquidity premium. Problem solved. We can now get a pure real interest rate, a precise measure of inflation expectations, a true measure of credit default odds, or a liquidity-adjusted price-to-earnings multiple.

Unfortunately, its not that easy. The only way to properly discover the price at which a buyer and seller of a particular instrument's liquidity services will meet is by fashioning a financial contract between them,  a financial derivative. These derivatives will trade in a market for liquidity or 'moneyness' that might look something like this. And therein lies the paradox. Much like the option and CDS of our previous example, this new derivative will itself be characterized by its own liquidity premium, thus impairing its ability to provide a clean measure of the original instrument's liquidity premium. We could fashion a second derivative contract to measure the liquidity premium of the first derivative contract, but that too will be compromised by its own liquidity premium, taking us down into an infinite loop of imprecision.

So... back to economic nihilism. Either that or a more healthy skepticism of those who confidently declare the economy to be in stagnation or the stock market to be a bubble. After all, there's a lot of static out there.

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Note: David Beckworth has also written about the difficulties of using bond yields as indicators of secular stagnation. (1)(2)(3). And now Nick Rowe has a post on secular stagnation and liquidity.

Beyond bond bubbles: Liquidity-adjusted bond valuation

Real t-bill and bond yields have been falling for decades and are incredibly low right now, even negative (see chart below). With an eye to historical real returns of 2%, folks like Martin Feldstein think that bonds are currently mis-priced and warn that a bond bubble is ready to burst.

Investors need to be careful about comparing real interest rates over different time periods. Today's bond is a sleek electronic entry that trades at lightning speed. Your grandfather's bond was a clunky piece of paper transferred by foot. It's very possible that a modern bond doesn't need to provide investors with the same 2% real coupon that it provided in times past because it provides a compensating return in the form of a higher liquidity yield.

[By now, faithful readers of this blog will know that I'm just repeating the same argument I made about equity yields.]

Here's a way to think about a bond's liquidity yield. Bonds are not merely impassive stores-of-value, they also yield a stream of useful services that investors can "consume" over time. In finance, these consumption streams are referred to as an asset's convenience yield. (HT Mike Sproul)

For instance, the convenience yield of a house is made up of the shelter that the house owner can expect to consume. A Porsche's convenience yield amounts to travel services. What about a bond's convenience yield? I'd argue that a large part of a bond's convenience yield is comprised of the liquidity services that investors can expect to consume over the life time of the bond. Let's call this a monetary convenience yield.

In an uncertain world, it pays to hold a portfolio of goods and financial assets that can be reliably mobilized come some unforeseen event. A fire alarm, a cache of canned beans, and a bible all come to mind. Liquid financial instruments, say cash or marketable bonds, are also useful since they can be sold off quickly in order to procure more appropriate items. This ability to easily liquidate bonds and cash is a meaure of their monetary convenience.

Even if the unforeseen event for which someone has stockpiled canned beans or bonds never materializes, their holder nevertheless will enjoy the convenience of knowing that in all scenarios they will be secure. The stream of uncertainty-shielding services provided by both a bond and a can of beans are "consumed" by their holder as they pass through time.

This monetary convenience yield is an important part of pricing bonds. Prior to purchasing a bond, investors will appraise not only the real return the bond provides (the nominal interest rate minus expected inflation) but will also tally up the stream of future consumption claims that they expect the bond to provide, discounting these claims into the present. The more liquid a bond, the greater the stream of consumption claims it will yield, and the higher its monetary convenience yield. The greater the stream of consumption claims, the smaller the real-return the bond need provide to tempt an investor into buying. (HT once again to Mike Sproul on consumption claims)

Which brings us back to the initial hypothesis. If the liquidity of government debt has increased since the early 1980s, then we need to consider the possibility that bonds are providing an ever larger proportion of their return in the form of a monetary convenience yield, or streams of future consumption claims. If so, the observed fall in real rates isn't a bond bubble. Rather, negative real rates on treasuries may reflect technological advances in market microstructure and improvements in bond market governance that together facilitate the increased moneyness of bonds. Put differently, investors aren't buying bonds at negative real interest rates because they're stupid. It's possible that investors are willing to accept negative real interest rates because they are being sufficiently compensated by improving monetary convenience yields on bonds.

I find this story interesting because we usually think that in the long term, real interest rates are determined primarily by nonmonetary factors, including the expected return to capital investments and the time preferences of consumers. The story here is a bit different. In the long term, real interest rates on bonds are determined (in part) by monetary forces. The higher a bond's monetary convenience yield, the lower its real interest rate. Oddly, bonds may be bought not by consumers who are willing to delay gratification, but by impatient consumers who want to immediately begin consuming a bond's convenience yield (ie. using up future consumption claims). The line between consumption and saving is blurred and fuzzy.

In my previous post on equities, I gave some numbers as evidence for the increased liquidity of stocks. Bonds aren't my shtick, so I won't try to prove my hypothesis. All I'll say is that the rise of repo markets would have contributed dramatically to bond market liquidity since repo increases the ability to use immobilized bonds as transactions media. Give Scott Skyrm a read, for instance.

There is a case of missing markets here. If we could properly prices a bond's monetary convenience yield, then we could get a better understanding of the various components driving bond market prices over time.

Imagine a market that allowed bond investors to auction off their bond's monetary convenience yield while keeping the real interest component. Thus a bond investor could buy a bond in the market, sell (or lease) the entire chain of consumption claims related to a bond's liquidity, invest the proceeds, and be left holding an illiquid bond whose sole function is to pay real interest. By stripping out and pricing whatever portion of a bond's value is related to its monetary nature, investors might now precisely appraise the real price of a bond relative to its real interest payments. Excessively high real prices relative to real interest would indicate overvaluation and a bubble, the opposite would indicate undervaluation and a buying opportunity.

But until we have these sorts of markets, we simply can't say if bond prices are in a bubble. Sure, real rates could be unjustly low because bonds prices have been irrationally bid up. But they could also be justly low if bonds are simply providing alternative returns in the form of monetary convenience. Without a moneyness market, or a convenience yield market, we simply lack the requisite information to be sure.

Some notes on market measures of inflation

I learnt some interesting facts about inflation-linked investment products. To begin with Sober Look had an intriguing chart showing an inversion in the TIPS yield curve.

Michael Ashton at Epiphany had an interesting explanation for this. Basically, short-dated TIPS begin to trade like gasoline futures. Like zero-coupon inflation swaps, TIPS are indexed to headline inflation, not core inflation. The most volatile component of headline inflation are gas prices, although in general large changes in gasoline prices will mean-revert to core inflation. We've had a large fall in gas prices, so near TIPS have fallen in value. More distant TIPS price in an expectation of gasoline reverting to core, and therefore are less sensitive to the fall in gas prices.

Michael explains here why inflation swaps are a better indication of true inflation than TIPS.

I learn here that the 5Y 5Y forward inflation curve is the market price for an inflation swap that starts in 5years and ends in 10 years.

In this post at David Glasner's blog, I point out that the fall in TIPS prices might not necessarily be a negative indicator. Starting with Michael's point about the sensitivity of near TIPS to gasoline prices, how much of the fall in gasoline prices is linked to fears of deflation, and how much to the massive rise in crude oil inventories coursing through North America? Domestic crude oil production is skyrocketing due to the technical combination of horizontal drilling and multiple stage fracturing. If this technological leap has contributed to the fall in energy prices, and the fall in energy prices has contributed to the fall in TIPS prices, then there is some component of ingenuity, and not wholly pessimism, at the core of the fall in TIPS prices.

Tipsy TIPS spreads

David Glasner noticed a very interesting anomaly yesterday. In short, 5-year TIPS rates seem to be rising while 10-year TIPS have been falling. He encouraged his readers to do some investigating to find out why. See my findings below.

TIPS: How to decompose the liquidity premium from the inflation-risk premium

Lars Christensen talks about the idea of setting a floor under inflation-linked bonds in order keep inflation expectations at some minimum level. It`s an interesting idea. Here is my comment:

Interesting idea, Lars. One problem here is that the TIPS spread (I’ll use US lingo if you don’t mind) measures not only expected inflation but also the relative illiquidity of TIPS relative to Treasuries. It measures, in part, a liquidity premium.

TIPS might fall to the central bank’s minimum buying price not because inflation expectations have fallen, but because the liquidity of TIPS relative to Treasuries has declined. This change in liquidity could be purely incidental. ie. it could be due to some unimportant technical change unique to Treasury markets. The result would be that the central bank buys up TIPS because it believes inflation expectations have fallen, when in actuality it is the liquidity premium that has changed. According to your rule, the money supply automatically increases, though perhaps it shouldn’t have.

In short, you have to find some way to decompose that portion of the spread between TIPS and Treasuries that is due to the liquidity premium and that which is due to inflation expectations.

It there were publicly traded “liquidity-options” on TIPS, you’d be able price the value of the liquidity premium and use that to back out that portion of the TIPS spread due purely to inflation expectations. Then you could apply your rule more precisely.

In a 2009 speech, FRBNY President William Dudley talks about the illiquidity premium and inflation-risk premium of TIPS here.

Inflation swaps and TIPS

Econbrowser has a post on inflation expectations as measured via TIPS spreads. This links back to an earlier comment I made on Glasner's blog, in which inflation swaps are posited as an alternative to TIPS spreads. Here is the comment from Econbrowser:

"One might worry about characteristics in the TIPS market distorting the estimates of the real yields."

 and

 "The real yield curve starts at five years, so one can’t be sure what the real yield curve suggests for the horizon less than five years. "

 Why not use zero coupon inflation swap prices? They (supposedly) don't suffer from some of the same distortions as TIPS (liquidity premia), and you can get shorter terms.

 For instance, here is the 2 year inflation swap.

 http://www.bloomberg.com/apps/quote?ticker=USSWIT2:IND

Just subtract the 2 year swap rate from the nominal 2 year rate and you have the 2 year real rate. 

See the Cleveland Fed's explanation of their methodology for measuring inflation expectations, which includes the use of  inflation swaps

Liquidity options, liquidity premium, natural interest rate, TIPS, and inflation swaps

Commented on David Glasner's Once Again The Stock Market Shows its Love for Inflation:

The only problem here is the one that we talked about in a previous post (Unpleasant Fisherian Arithmetic) concerning the liquidity premium that assets carry. The reason for the rising TIPS spread could be (though not necessarily must be) that the liquidity premium on treasuries is shrinking relative to that of TIPS, and therefore TIPS are rising in price relative to Treasuries. This makes it hard to pass judgment on the hypothetical rate of return on capital.

 Anyways, you have already commented on this problem in your paper: “One possible cause of distortion in the yield on TIPS bonds and in the TIPS spread during the autumn 2008 financial crisis is that the yield on conventional Treasuries was depressed because of a liquidity premium. Even though the ex ante real interest rate was likely negative, because TIPS bonds were perceived as much less liquid than conventional Treasuries, TIPS bonds could not be sold unless they were discounted, so that their yields rose well above the (unobservable) ex ante real rate on holding real assets.”

 We were talking in the comments of the “Unpleasant Fisherian Arithmetic” post about how one could measure liquidity. I thought a bit about this. If there were a market for financial products, say options, that managed to price the pure value of an underlying asset’s liquidity premium, then you would be able to measure the value that the market placed on assets’ relative liquidity premiums and, from there, get a better idea for what portion of an assets total return is provided by an own-rate and what is provided by a liquidity premium. These sort of financial assets don’t exist, but if they did they would probably be sort of like credit-default swaps… more like liquidity-guarantee swaps.

Note that is follows from a previous comment I had concerning the impossibility of computing the natural rate of interest because liquidity interferes. See Unpleasant Fisherian Arithmetic

David responded:

Have you looked at how the Cleveland Fed tries to extract the inflation expectation from the TIPS spread?

I responded:

 I looked at it this morning. It seems to me that the Cleveland Fed is using alternative measures to extract inflation expecations given the problems posed by illiquidity in TIPS markets. They are including the inflation swaps market. In an inflation swap, one party pays a fixed interest rate, the other pays the inflation rate.

 Apparently swap markets didn’t suffer as much as TIPS markets did from liquidity problems in 2008, and for that reason the Cleveland Fed is using swap rates as one of their main indicators of inflation expectations.

 That being said, swaps are still traded contracts and bear some sort of liquidity premium, so it is still empirically impossible to back out a real rate without knowing what that premium is.

 For your records, here is the quote page for the 2 year USD dollar inflation swap spread: http://www.bloomberg.com/apps/quote?ticker=USSWIT5:IND

The Cleveland Fed discuss their methodology here. http://www.clevelandfed.org/research/workpaper/2011/wp1107.pdf