Friday, April 26, 2024

The direction of causality may change through time - the challenge for investors


This is still one of the key issues within macro-finance. What is the line of causality between the movement of two assets and what are the unknown drivers that may impact both assets? Tests of causality can be conducted, but that provides just a glimpse of what could be the driver of returns. 

The problem becomes even more difficult when looking at policy responses. Does inflation drive central bank action or does central bank action drive inflation? We know there is a relationship between the two; however, the direction of causality may change through time. Policy drives inflation until there is a point when the target variable drives policy. To be successful, an investor needs to anticipate the change in causality.

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