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

By Simons, Howard L. | Modern Trader, April 2004 | Go to article overview

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


Simons, Howard L., Modern Trader


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.

[GRAPHIC OMITTED]

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. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

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
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Author Advanced search

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.