Incorporating Inflation

Nothing so weakens government as persistent inflation.

—John Kenneth Galbraith

In designing price-forecasting models, it is essential to keep in mind that the measure of prices—the dollar—is itself a variable. Thus, using nominal prices to compare widely separated years makes as much sense as comparing the dollar price of a commodity in one season to the euro price in another season. It is safe to say that any model that does not adjust for inflation is critically flawed.

Figures 25.1 through 25.4 illustrate the difference between nominal and inflation-adjusted prices in different futures markets from 1995 to 2015. These charts illustrate that adjusting for the effect of inflation can alter the relationship between past highs and lows, as well as the relative magnitudes of prior past moves. For example, in Figure 25.1, the 2004 highs in lumber nearest futures were above the 1996 and 1999 highs in nominal terms (solid line), but lower than these previous peaks on an inflation-adjusted basis (dashed line). In Figure 25.2, in March 2004 soybean nearest futures eclipsed their March 1997 high on a nominal basis, but the inflation-adjusted series made a lower high in March 2004.

Finally, in Figure 25.4, the nominal price graph reflects a strong uptrend in live cattle prices during 1995 through 2011 (the sharp correction in 2008 notwithstanding), while the inflation-adjusted price series moved essentially sideways during the same period, with little ...

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