Money, Banking, and Financial Markets

Understand the principles, understand the future

Policy, especially monetary policy, is about numbers. Is inflation close to target? How fast is the economy growing? What fraction of the workforce is employed?  And, what is the relationship between the policymakers’ tools and their objectives? Answering all of these questions requires measuring a broad array of economic indicators, with consumer prices high on the list. In this post, we discuss some of the pitfalls in measuring prices.

Price indices of the sort that we use today have been around since the late 19th century. In the United States, near the end of World War I, the National Industrial Conference Board starting constructing and publishing a cost-of-living index. This work was eventually taken over by the Bureau of Labor Statistics (BLS). Over the past century, the theory of price indexes (see, for example, here and here) and the means of measurement have both moved forward substantially.

With the advent of inflation targeting, price indices have taken on a new prominence. If monetary policymakers are going to focus on controlling inflation—setting numerical targets for which they are then held accountable—then the construction of the price index itself becomes an issue. What is included and how can become critical to the way policy is conducted and to the achievement of the stated objective, namely price stability....

For decades, textbooks on international economics and finance built a part of their scaffolding on the foundation of a relationship called covered interest parity (CIP). CIP postulates that, in a world of free capital flows, currency-hedged returns on equivalent-risk assets will equalize across countries. For example, the return to investing in a 1-year U.S. Treasury bill will equal the return to purchasing euros, investing the proceeds in a 1-year German Government liability, and purchasing a contract guaranteeing the future euro/dollar exchange rate at which the euros will be converted back to dollars a year later. In practice, the CIP relationship was such a reliable feature of international fixed-income markets that for decades one could think of banks operating a nearly costless CIP machine to perform what many viewed as a riskless arbitrage.

Then, one day, the CIP machine broke down. It first stopped working in the Great Financial Crisis (GFC) of 2007-2009, when counterparty and liquidity risks both skyrocketed, raising the possibility of defaults and losses in executing the trades necessary. That is, CIP was not a riskless arbitrage.

As a wave of recent research highlights, the conventional, pre-crisis model of the CIP machine remains impaired even as the counterparty and liquidity risks that characterized the GFC have receded....


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... the site where you can learn about finance and economics. We provide commentary on events in the news and on questions of more lasting interest. Because the financial system is constantly evolving, our analysis is informed by a set of core principles: understand the principles, understand the future. The opening excerpts of our two most recent posts appear above. For prior posts, click on the Commentary link to the left, or on the month-by-month Archives to the right. Alternatively, if you are interested in a specific topic, use the tags.

The site also provides material related to our textbook, Money, Banking and Financial Markets, 4th edition, 2014. The Five Core Principles on which the book is based are highlighted here. In addition, Cecchetti and Schoenholtz 4e systematically integrates the use of economic and financial data from FRED, the online database provided by the Federal Reserve Bank of St. Louis. Click on FRED Lessons on the left to access help on how to use this incredible resource.

Steve Cecchetti and Kim Schoenholtz


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