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Inflation and CPI

Inflation and CPI

Thomas Long, Course Instructor

The CPI is the most widely used measure of inflation and is sometimes viewed as an indicator of the effectiveness of government economic policy.  It provides information about price changes in the nation's economy charged to government, business, labor, and private citizens.  It is customarily used by them as a guide to making economic decisions.  In addition, the President, Congress, and the Federal Reserve Board use trends in the CPI to aid in formulating fiscal and monetary policies.

The Consumer Price Index is the average change over time in the prices paid by urban consumers for a “market basket” of consumer goods and services.  The CPI basket is developed from detailed expenditure information provided by families and individuals on what they actually bought.  Most of the specific CPI indexes in the USA have a 1982-84 reference base.  That is, the Bureau of Labor Statistics (BLS) sets the average index level (representing the average price level) for the 36-month period covering the years 1982, 1983, and 1984-equal to 100.  The BLS then measures changes in relation to that figure.  An index of 110, for example, means there has been a 10% increase in price since the reference period; similarly, an index of 90 means a 10% decrease.  For the current CPI, this information was collected from the Consumer Expenditure Surveys for 2005 and 2006.  It is not an exact record of individual households’ spending, but it gives a good idea of how price increases affect typical household spending, and the change in one dollar’s ‘buying power’ because of inflation.

The CPI is comprised of all goods and services purchased for consumption by the reference population.  Major groups and examples of categories in each are as follows:

•    FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)

•    HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)

•    APPAREL (men's shirts and sweaters, women's dresses, jewelry)

•    TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)

•    MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)

•    RECREATION (televisions, toys, pets and pet products, sports equipment, admissions)

•    EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories)

•    OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

The change shown month-to-month or year-to-year by comparing index numbers is usually expressed as a percentage – for example, ‘consumer prices have increased by 0.3 percent since last month'.

This percentage change is often referred to as the inflation rate – eg, ‘the inflation rate for the last 12 months is 2.5 percent'.

This graphic shows the effect of the inflation rate on the price of a basket of goods. If the year’s inflation rate was 2.5 percent, the same selection of goods that cost $400 12 months earlier, can now be purchased at a cost of $410.

                cpi 1

Many investors and the Fed constantly monitor this figure to get an understanding about the future of interest rates.  Interest rates are significant because, in addition to having a direct impact on the amount of capital inflow into the country, they also say much about dollar-based carry trades.  If the inflation number comes in higher than expected, traders will interpret that to mean that an interest rate hike is more likely in the near future and will thus buy the currency, whereas a figure that falls short of expectations may cause traders to wait on the sideline until the Central Bank actually makes a decision. Essentially, trading a negative change in CPI is much more difficult than trading a positive change due to the nature of different interpretations.  A significant increase in the CPI will result in much bullishness, but a decrease will not necessarily result in bearishness.  The CPI measures inflation at the retail level (consumers), while the PPI (Producer’s Price Index) measures the inflation at the wholesale level (producers).

In the United States, the CPI numbers come out once a month.  When the numbers come out (around the middle of each month), they reflect the data for the prior month.  CPI is also released monthly in Europe, the UK, Canada, and Japan.  Many other countries release this data only quarterly.  The dates of these announcements and many other pieces of fundamental trading data can be followed at the Daily FX Global Economic Calendar which can be accessed at http://test.dailyfx.com/calendar/.

As you continue through the lessons on Fundamental Analysis, the interrelatedness of each of these areas becomes more and more apparent.  Keep this in mind as you review the other lessons so you can assemble a complete picture.

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