Academic journal article Journal of Money, Credit & Banking

Should Central Banks Target CPI Futures?

Academic journal article Journal of Money, Credit & Banking

Should Central Banks Target CPI Futures?

Article excerpt

I consider recent proposals that the government should attempt to stabilize the nominal value of a CPI futures contract. Under a variety of conditions arbitrageurs will break the peg and bankrupt the central bank, the central bank ends up in a gaming problem with private traders, or the regime collapses into discretion.

Some economists recently have suggested that the central bank target a comprehensive futures price index. Under these proposals, the central bank would attempt to peg the nominal price of a CPI futures contract, and in doing so, would provide an anchor for the price level. When reduced to their fundamentals, explained in more detail below, these plans require the central bank to trade futures contracts with the private sector and thus to make cash bets on the future course of spot prices. These cash bets supposedly bind the central bank to achieving prespecified spot price targets and institute a regime of rules rather than discretion.

The idea of futures price targeting seems to have originated with Barro (1979), although he does not advocate such a policy. Advocates of futures price targeting include Sumner (1989, 1992, 1995), Glasner (1989), Hetzel (1990), Woolsey (1992, 1994), Dowd (1994), and Sumner and Woolsey (1995). Closer to mainstream practice, central banks have been paying increasing attention to futures prices as indicators of inflation, even if they do not target such prices as a policy rule.(1)

CPI futures price targeting attempts to circumvent the impact and measurement lags associated with stabilizing spot CPI prices. CPI futures prices react immediately to new information and can be read without delay (as we will see below, however, these advantages may be problematic). Sumner (1992, p. 491) notes: "the profession continues to advocate a wide variety of policy proposals that would appear to be dominated by index futures convertibility."(2)

CPI futures targeting avoids some of the drawbacks of commodity bundle standards. Commodity bundle monies are limited to those few commodities that are easily defined, homogeneous in quality, traded in highly liquid markets, and easily stored Friedman 1951). Futures targeting, in contrast, can cover the entire array of goods found in today's consumer price index without requiring direct convertibility. The futures bundle can be highly diverse, and can measure actual purchasing power closely. The chosen index can include the prices of items that are illiquid or not easily stored, such as services and perishable commodities.

Following many futures contracts today, CPI futures would use "cash settlement." Rather than delivering the CPI bundle itself, traders would deliver a value-equivalent amount of cash, T-bills, gold, or whatever other settlement asset is specified. The value of the futures contract, at expiration, is defined as equal to the value of the spot index. In this manner the futures contract can be settled without requiring actual delivery. In effect, futures contract traders are making cash bets on the future level of the CPI.(3)

In this essay I wish to flesh out the mechanics of futures price targeting. Specifically, plan proponents have not provided a systematic account of the arbitrage opportunities that private traders may hold against the central bank, and how the central bank must act to limit such opportunities. It turns out that futures price targeting is not sustainable under all conditions. I do not question whether price level stabilization is desirable, or whether the central bank should forsake monetary discretion. I take the implementation and goals of the plan as given, and consider whether the plan provides a feasible monetary regime. Section I describes the proposals in more detail. Section 2 presents the core of the critical analysis and considers the gaming problem between traders and the central bank, under a variety of assumptions. Section 3 considers whether the proposal dominates traditional spot price level targeting. …

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