Must know: This week's releases and the upcoming FOMC meeting (Part 4 of 8)
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.
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.
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.
Browse this series on Market Realist:
- Part 1 - Must know: Why is this week important for the US economy?
- Part 2 - Why the bond market is affected by the Industrial Production Index
- Part 3 - Where to house your funds: Let the Housing Market Index guide you
- Budget, Tax & Economy
- Consumer Price Index