An inflation indicator: What does the Consumer Price Index say?

Market Realist

Must know: This week's releases and the upcoming FOMC meeting (Part 4 of 8)

(Continued from Part 3)

The Consumer Price Index (or CPI), issued monthly by the Bureau of Labor Statistics, is a measure of the change in the average price level of a fixed basket of goods and services purchased by consumers.

The Fed’s preferred inflation measure is the Personal Consumption (or PCE) Price Index, and not the CPI, because it reflects what consumers are actually buying during any given period, as the component weights are updated annually while those for the CPI are updated infrequently. However, the sub-component price data of the CPI are used to compile the PCE Price Index. So, the CPI and the PCE Price Index are inextricably linked.

As can be seen in the chart above, the CPI is more volatile than core CPI. Large fluctuations in the CPI are often due to the food and energy components, which account for over one-fifth of the CPI. Weather conditions affect both the CPIs to a large extent. As a result, economists and financial market participants prefer to monitor the CPI excluding food and energy prices for its greater monthly stability, also referred to as the core CPI.

Investor’s takeaway

CPI is the most widely followed monthly inflation indicator. 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, as the CPI is widely used as a cost of living measure for contract adjustment purposes.

To negate the effect of inflation on their holdings, investors often invest in ETFs like the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which has its major holdings in companies like Citigroup (C) and JPMorgan Chase & Co. (JPM), the Vanguard Short Term Corporate Debt ETF (VCSH), and the PowerShares Senior Loan Fund (BKLN), that are designed to protect the investors against interest rate risk caused by inflation.

The bond market will rally when increases in the CPI are small and vice-versa. The equity market also rallies with the bond market because low inflation promises low interest rates and is good for profits.

Continue to Part 5

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