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

Supply and Demand

We had an interesting lecture recently in our Economics class about supply and demand. One of the more interesting examples demonstrated what happens when public policy artificially shifts the demand slope. The example highlighted the rent control policies in New York City. Because prices were kept artificially low, demand for apartments skyrocketed. The demand was so great at times that people could be seen standing outside the newspaper offices in the wee hours of the morning so that they could be the first to get a jump on newly available apartments. Here's the interesting part. They weren't looking at the classified, they were looking through the obituaries.

The lesson learned was that as some costs are artificially kept low (rent), other costs increase, like the obtrusive behavior of someone showing up on your doorstep early in the morning the day after your loved one passed away to ask for their apartment. The class discussion wasn't that rent control and other policies that interfere with natural supply and demand are bad necessarily, it was that there will always be other costs associated when supply or demand is shifted artificially, and these things need to be considered when establishing policy.

This is just one example of a situation where economics has something to say. I'm finding the Jenkins MBA course material very interesting and I can see how having a solid understanding of economics as a manager will be a very beneficial thing for my future career.