Can the CPI Catch Your Eye? the CME Has Delved into the Market of Tradable Macroeconomic Indicators with CPI Futures. before You Consider Trading This Market, You Should Carefully Consider the Economic Forces Behind the CPI's Valuation

Article excerpt

If you cannot add, then do not trade. Before you protest either your virtue or your arithmetic abilities in whichever order you choose, consider the difficulties posed by Fisher's Law, which states that nominal interest rates are the sum of an underlying real interest rate plus the expected rate of inflation. The problem is neither the real rate of interest nor the expected rate of inflation can be known at any one time.

Some thought the advent of Treasury Inflation Protected Securities (TIPS) in 1997 solved this problem. TIPS are T-bonds whose principal is adjusted higher by the non-seasonally adjusted all-urban consumer price index (CPI-U). The CPI-U is a Laspeyres index, which measures the price change p of a fixed basket of goods q over time, and is known to be an imperfect inflation measure. It ignores economic realities such as price elasticity of demand, substitution and technological improvement, so-called hedonic adjustments aside. Moreover, the Bureau of Labor Statistics surveyors who collect the data face problems of handling discounting and non-price incentives:

[P.sub.l] = [[summation][p.sub.n][q.sub.0]]/[[summation][p.sub.0][q.sub.0]]

The GDP deflator, by contrast, is a Paasche index, which measures the price change p from 0 to n not over the original market basket [q.sub.0] but over the final market basket [q.sub.n]:

[P.sub.p] = [[summation][p.sub.n][q.sub.n]]/[[summation][p.sub.0][q.sub.n]]

The Paasche index is more difficult to compile, and it arrives on a leisurely quarterly schedule with the first estimate of the GDP. These releases are subject to substantial revision. As a result, the monthly CPI-U with all of its imperfections has become the "good enough for government work" inflation measure even though the cumulative difference between the two deflators--the GDP deflator is adjusted to the June 1947 CPI level of 22--is considerable (see "Different inflation measures," below).

Even more important for our purposes, the CPI-U is once again the basis for a futures contract. (The Coffee, Sugar & Cocoa Exchange, now part of the New York Board of Trade, prematurely and unsuccessfully launched a similar futures contract in 1987.) The new contract, which commenced trading in February, represents the Chicago Mercantile Exchange's (CME) first foray into a macroeconomic indicator and is designed to serve a growing market for such derivatives.

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MARCH FORWARD, LOOK BACKWARD

Whether from a Laspeyres or Paasche index, the measure of inflation arrived at is a backward-looking snapshot, while the yield to maturity on T-bonds embeds a forward-looking inflation expectation. If we simply subtract annualized CPI-U changes from the nominal yields on T-bonds of 10 years' maturity or longer, (10 years only since July 2000) we derive at a wildly fluctuating measure of the real rate of interest (see "The difference is not the real rate," right).

This contradiction of economic theory is nothing more than an artifact of an apples-and-oranges comparison between a term maturity instrument, the T-note, and a datum with no particular time dimension, the CPI-U. The suggestion that you could create a do-it-yourself TIPS by combining a regular T-note with a futures contract on the CPI-U reflects an imperfect understanding of the dynamics involved for both.

A PEEK BEHIND THE FIG

Before delving further into the nature of inflation hedges, let's recognize the work that has been done in trying to forecast inflation. The Economic Cycle Research Institute (ECRI) has developed a forward inflation gauge (FIG) containing:

1. The Journal of Commerce materials price index;

2. Growth in real estate loans;

3. The insured unemployment rate, treated on an inverse basis;

4. The yield spread between the 10-year note and the 6-month bill, also treated on an inverse basis;

5. …