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Consumer Price Index
By: fxvictory Date: December 10, 2014, 9:32 pm
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Definition
The Consumer Price Index is a measure of the change in the
average price level of a fixed basket of goods and services
purchased by consumers. That is the index shows the change in
price levels since the index base period, currently 1982-84 =
100. Monthly changes in the CPI represent the rate of inflation.
The consumer price index is available nationally by expenditure
category and by commodity and service group for all urban
consumers (CPI-U) and wage earners (CPI-W). All urban consumers
are a more inclusive group, representing about 87 percent of the
population. The CPI-U is the more widely quoted of the two,
although cost-of-living contracts for unions and Social Security
benefits are usually tied to the CPI-W, because it has a longer
history. Monthly variations between the two are slight.
The CPI is also available by size of city, by region of the
country, for cross-classifications of regions and
population-size classes, and for many metropolitan areas. The
regional and city CPIs are often used in local contracts.
The Bureau of Labor Statistics also produces a chain-weighted
index called the Chained CPI. This measures a variable basket of
goods and services whereas the regular CPI-U and CPI-W measure a
fixed basket of goods and services. The Chained CPI is similar
to the personal consumption expenditure price index that is
closely monitored by the Federal Reserve Board.
Why Investors Care
The consumer price index is the most widely followed monthly
indicator of inflation. An investor who understands how
inflation influences the markets will benefit over those
investors that do not understand the impact.
Inflation is an increase in the overall prices of goods and
services. The relationship between inflation and interest rates
is the key to understanding how indicators such as the CPI
influence the markets- and your investments.
If someone borrows $100 dollars from you today and promises to
repay it in one year with interest, how much interest should you
charge? The answer depends largely on inflation as you know the
$100 will not be able to buy the same amount of goods and
services a year from now. The CPI tells us that prices rose 4.2
percent in the U.S. over 2007. To recoup your purchasing power,
you would have to charge 4.2 percent interest. You might want to
add one or two percentage points to cover default and other
risks, but inflation remains the key factor behind the interest
rate you charge.
Inflation (along with various risks) basically explains how
interest rates are set on everything from your mortgage and auto
loans to Treasury bills, notes and bonds. As the rate of
inflation changes and as expectations on inflation change, the
markets adjust interest rates. The effect ripples across stocks,
bonds, commodities, and your portfolio, often in a dramatic
fashion.
Importance
The consumer price index is the most widely followed monthly
indicator of inflation. The CPI is considered a cost-of-living
measure since it is used to adjust contracts of all types that
are tied to inflation. Labor contracts are tied to changes in
the CPI; Social Security payments are tied to the CPI; and even
tax brackets are tied to the consumer price index.
For monetary policy, the Federal Reserve generally follows
"headline" and "core" inflation. This latter measure excludes
the volatile food and energy components. The Fed's preferred
inflation measure is not the CPI but the personal consumption
price index because it reflects what consumers are actually
buying during any given period-the component weights are updated
annually while those for the CPI are updated infrequently.
However, the subcomponent price data of the CPI are used to
compile the PCE price index (PCE prices are released almost two
weeks after the CPI). Thus, the CPI and the PCE price index are
inextricably linked. In the long run, the overall CPI and core
CPI track each other.
Interpretation
The bond market will rally (fall) when increases in the CPI are
small (large). The equity market rallies with the bond market
because low inflation promises low interest rates and is good
for profits.
Economic data tend to be volatile from month to month; the CPI
is no exception. Large fluctuations in the consumer price index
are often due to the food and energy components. Weather
conditions affect both to a large extent. OPEC, the oil cartel,
also affects energy prices. As a result, economists and
financial market participants prefer to monitor the CPI
excluding food and energy prices for its greater monthly
stability. This is also referred to as the "core" CPI. Oddly
enough, items that make part of the "core" also include
discretionary goods and services. And while food and energy
prices are excluded because of their monthly volatility, what
can be more "core" than food and energy? Food and energy prices
account for a little more than one-fifth of the CPI.
The consumer price index has evolved over time as consumer
expenditures changed. Commodities now make up only 40 percent of
the index and the remaining 60 percent are services. It is
useful to monitor goods and services separately since prices of
goods are more volatile than prices of services.
Usually, when investors refer to the real rate of interest, they
use the year-over-year rise in the CPI to subtract from an
interest rate, such as the 10-year Treasury note.
Frequency
Monthly
Source
Bureau of Labor Statistics (BLS), U.S. Department of Labor
Availability
Around mid-month.
Coverage
Data are for one month prior to release month. Data for June are
released in July.
Revisions
No
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