Tuesday, February 1, 2011

Laspeyres, CPI, and Bond Rates, Oh My!

I'm sure that catchy and fascinating title caught your eye. Before I lose all of you to the slow glazing over of eyes and ever increasing slack jaw, let me explain the title and why this could influence whether you retire in Venice Beach, CA or Vinnie's retirement village.

First, in brief, a Laspeyres index is what is used to develop the Consumer Price Index (CPI) which measures how much goods are increasing in price over time, otherwise known as inflation. The problem that Economists have with the Laspeyres index is that they think it overstates the actual effect of inflation by as much as 1% and that a 3% rise in inflation really doesn't leave us a full 3% less well off, income staying the same. We won't get into the details of why it might overstate the effects of inflation but we will focus on one benefit of this overstatement.

So, why is this of interest to you and me? There are two main types of U.S. Treasury backed securities that are tied to inflation and specifically to the CPI. These securities are I Bonds and TIPS (Treasury Inflation Protected Securities). In a nutshell, these Bonds provide a set yield or base rate and then adjust based on inflation. So for example, if the base rate is 1.5% and the CPI index states that inflation was 3%, the yield would be 1.5% + 3% for a 4.5% yield. Economists' problem with the Laspeyres index used for CPI would seem to indicate that the actual inflation effect was only 2% in this example therefor providing a 1% higher realized yield than intended. While a 4.5% yield isn't much, it is completely safe since it's backed by the US Government. Trust me, if the Government defaults on its obligations you will have much bigger problems than your yield rate.

Where you might benefit from this is by being able to reduce your exposure to riskier investments and moving into more secure options as you come closer to meeting your retirement goals. Practically speaking then, if your retirement goal is to make X percent over inflation you might actually be able to meet that goal with lower risk than you initially thought--as long as we don't develop another index that correlates better with the actual effects of inflation. Venice Beach is nice this time of year.

To further explore this topic in detail here's a much more academic read. Journal of Economic Perspectives: Getting Prices Right

No comments:

Post a Comment