Consumer Price Index (CPI): An Important Measure of Inflation

Regardless of our profession, and interest in economics or trading, we are all familiar with the concept of inflation. We experience its consequences every time we head to the grocery, or the gasoline store. Rising prices erode our purchasing power, and if wages remain constant, make us poorer, and lower our living standards. The importance of inflation as a measure of social and economic stability and an indicator consumer welfare is apparent. High inflation makes the life of fixed-income earners miserable, complicates the task of corporate planning, and blurs the vision of politicians and economics as they try to sort out the problems of the economy.

Although it is easy to perceive price rises in a particular product (especially if it is widely consumed and used by the public), it is difficult to be aware of the general change in price levels across product categories in the absence of a systematic approach. The price of bread may rise by 20 percent in a year, but that would hardly be a cause for concern if the prices of other foodstuffs were falling, or remaining constant. The tool used to identify price changes across product categories relevant to the consumer is the consumer price index (CPI), which is used by traders, politicians, and analysts for analyzing price movements, market trends, and determining economic policy.



We should note that the CPI only includes products which are utilized by the consumer for his needs. It’s different from the PPI in that it doesn’t include any raw materials, or intermediate goods useful to factories and firms. It differs from the GDP deflator because the latter measures price changes in everything produced within a nation’s borders, not just consumer goods, and also excludes the price of imports. The purpose of the CPI is measuring price changes which are relevant to the consumer, and as such, the components of the goods that go into its creation are only those of immediate relevance to the consumer.

The methods for the calculation of the CPI differ from nation to nation. Each national statistical institute employs a slightly differing method in the calculation of the data, and, for example, the European Union uses a Harmonized-CPI in order to bring the varying approaches of its constituent nations into alignment with each other. The calculation of CPI in Zimbabwe, for example, is very different from the way its calculated in the U.S., because the unhappy people of Zimbabwe cannot make use of many items consumed by U.S. citizens.

If the CPI is rising, the economy is going through a phase of inflation. Prices are rising, and consumers find it expedient to purchase a needed item as soon as possible, in order to avoid having to buy it at a higher price. The economic situation where the CPI value falls below zero is called deflation. In this case prices are falling, and consumers have less incentive to hasten the next trip to the stores due to the expectation that the next time prices will be cheaper. Deflation is the nightmare of central bankers, because conventional tools are highly ineffective in fighting it. There’s no upper limit to how high the central bank rate can rise to combat inflation, but rates can go only as low as zero. As such, central banks react vigorously to any threat of inflation by lowering rates preemptively, with the hope that prices will begin to rise before the anticipation of deflation has replaced the expectation of perpetually rising prices over the long term in the minds of consumers.
Use for forex traders

The main use of the CPI release for all traders, including currency speculators is its role as a major determinant of interest rates for central banks. Modern central banks increasingly regard the inflation rate as the main target of policies, and due to the importance of the central bank rate to economic trends, the CPI serves as an early warning indicator of changes in central bank policy directions.

The immediate reaction to the CPI can be anything from negligible to chaotic, depending on how unexpected the release is. Even a very high number will fail to move the market much if it is in line with the existing course of the central bank, and is anticipated as such. But even small deviation from the anticipated direction can cause traders to reassess their policies, leading to fluctuations and turmoil in the market.

Apart from its role as a guide for future central bank policies, the CPI release can be useful in predicting the course of national politics, due to the tendency of voters to punish governments which cannot help them at times of rising prices. High gasoline or food prices often correspond to political chaos: the experience of many Latin American nations, Indonesia, Turkey, Russia, and some former Soviet Republics, among others, during the 1990s, as well as the history of political chaos in the U.S. during the high inflation era prior to the election of President Reagan all show clearly how important the CPI can be for political analysis. And since legislation, and political decisions can be some of the most important drivers of economic trends, the role of the CPI in this type of analysis is clear.

Currency trends over the long term are strongly depending on central bank interest rate differentials. As such, it is possible to anticipate that among two nations with similar economical structures, the currency of the nation with the higher inflation rate will appreciate over time. Thus, even a simple comparison of basic CPI rates across nations can give us some clues on which currencies are likely to rise in value. For example, during the period of 2002-2007, Australian inflation has been consistently above the inflation level of the United States. During the same period, inflation in the United States has been higher than Japanese CPI. The result is reflected in currency prices: The Australian dollar appreciated against the U.S. dollar, while the dollar itself rose against the yen, during the time period in question.

Needless to say, if we want to create complete picture of price dynamics, we need to consider the CPI in conjunction with many other variables such as the GDP, current account, and global conditions. A high CPI value is indicative of growth and rising demand (and an appreciating currency) only if the central bank acts responsibly to control it. Otherwise, runaway inflation will lead to investor disillusionment, capital flight, social discontent, and political turmoil. We should also note that developing nations are able to tolerate a permanently elevated CPI level better than mature economies. As a result, the inflation targets of nations like Indonesia, Turkey, Brazil, or India are usually higher than those like Britain, or the European Union.
Calculation of the U.S. CPI

The data used to calculate the CPI is collected by the BLS (Bureau of Labor Statistics) in the U.S. in 87 urban areas from 50,000 housing units, and around 23,000 retail establishments.

Apart from the actual prices charged by the various retail outlets such as gasoline stations, groceries, hospitals, and many others, the CPI incorporates the various taxes related to the purchase and use of consumer items. Once every two months, a general survey of each household and retail institution is conducted to calculate the CPI value. During the month in between, a survey of only the major areas yields the headline number. Fuel prices and a few other items, on the other hand, are surveyed on a general basis every month.

The CPI is calculated by averaging the price changes in various items and weighing them according to their importance in the consumer’s balance sheet. Thus, although both the price of jewelry, and the price bread are measured for the calculation of the CPI, they are given different weightings and a change in the price of a loaf of bread is reflected by a greater change in the value of the price index.

We need not concern ourselves with every single detail of the calculation of the CPI release, but there is one important point to be kept in mind while analyzing this piece of data. Although the CPI breakdown includes an item termed housing, it only measures, rent, and a concept called owner’s equivalent rent, along with various costs associated with housing, such as furnishings, energy, and similar components. As such, the CPI does not include asset prices, like stock or housing prices (although owner’s equivalent rent tries to capture house price changes, it is extremely ineffective). There are two main results of this. First, rampant rise in housing prices can occur without ever catching the attention of the central bank, since it is not included in the CPI, and is not regarded an important part of the inflation equation discussed at each meeting of the Fed. Second, asset balloons, such as the mortgage bubble of this decade, and the stock market euphoria of the 90s cannot be anticipated or prevented by the institution. Traders must keep in mind that asset prices, can mask a large amount of underlying inflation by taking out a large chunk of money from the market which would otherwise create consumer inflation evident in the CPI release.
Components of the CPI

The CPI, released by the Bureau of Labor statistics (BLS), is composed of the following items

Food and Beverages: As the name suggests, this item included items like water, bread, and cakes.

Housing: This item is broken down into shelter, household energy, and household furnishings and operations components. The shelter component measures rent, and owner’s equivalent rent, energy measures the cost of heating and electricity, while the furnishings component measures expenditure items related to decoration and similar expenses. This item also measures changes in hotel fees.

Apparel: This index measures price changes in clothing items.

Transportation: The transportation index is composed of the new vehicle index, the used cars and trucks index, the public transportation and motor fuel indexes.

Medical Care: The medical care index measures changes in doctors’ fees, drug costs, and the cost of hospital accommodation, among other items.

Recreation: The recreation index measures price changes in items like cinema tickets.

Education and Communication: This index includes the price indices of such items like mobile phones, computers, books, and similar goods and services.

Other goods and services: This item measures the price changes in expenditure categories not included in the others, such as the cost of tobacco.

Apart from this general breakdown of the CPI release, there are a few special indices created for measuring the underlying trend in different consumption categories. The most important among those is the core CPI index which is calculated by excluding the food and energy prices from ordinary CPI release. Food prices are highly seasonal, and respond strongly to perceived changes in the supply and demand situation, as well as fluctuations in the commodity market. Energy prices are even more responsive to volatility in commodity prices. These two items are independent of consumer demand to some extent, and depend on external factors which are outside of the control of government officials and policy makers. To better measure changes in consumer behavior, and the pricing policies of firms, economists and traders sometimes use the core-CPI value. It is important, however, to keep in mind that the core-CPI is an imaginary concept with no real relevance to firms or individuals who still need to burn gasoline and eat, and pay for them, regardless of the causes behind the price dynamics.
Revisions and benchmarks

The CPI release includes both seasonally adjusted, and seasonally non-adjusted raw data. The raw data is prone to be misleading on price trends due to its tendency to be distorted higher or lower as a result of seasonal factors such as changing climatic conditions, production cycles, model changeovers at factories, holidays, and sales. As such it is widely disregarded by the analyst and trader community. Its greatest utility is for consumers who want to have a deeper knowledge on the actual prices they are paying. It is also used in collective bargaining contract agreements between labor unions and employers. The seasonally adjusted data smoothens out the seasonal factors, and provides a more reliable picture of underlying trends.

Each year the BLS revises the CPI numbers of the previous five years in light of data newly available and releases the revisions to the public. After five revisions the data is final and is not reviewed further.
Inflation Expectations

The Fed does not depend on the CPI number alone while setting interest rates. It also depends on a concept termed “inflation expectations” while determining future policy. “Inflation expectations” is a somewhat shady concept about where the public perceives the inflation rate to be heading. If the CPI is rising, for example, and long and medium term inflation expectations remain “anchored”. As the term goes, it’s likely that the Federal Reserve will do nothing to counter the trend.

The concept of inflation expectations is a fluid one. It takes into account various consumer surveys on future inflation, along with the so-called TIPS breakeven rate along with the actual CPI rate, to reach conclusions about the Federal Reserve’s credibility before the American public. Although it
Other CPI releases

Although the BLS releases its CPI statistics every month, regional branches of the Federal Reserve have their own versions of the CPI release. These releases are mostly statistical variations on the raw CPI data, and they can be accessed at the relevant pages of the various regional Federal Reserve branches.
Conclusions

Let’s summarize some of the important points discussed in this article CPI calculates consumer prices

The CPI measures price changes in all consumer goods, but does not include intermediate goods, raw materials, or similar items in its calculation. It is released by the Bureau of Labor Statistics each month, and revised on a yearly basis. The seasonally adjusted data is widely used by economists and analysts for gauging price trends, and predicting future Federal Reserve policy.
CPI does not include asset prices

CPI only measures price changes in consumption items, and as such, does not measure the impact of asset bubbles on the consumer’s balance sheet, or the economy at large. Asset prices have wide implications on consumer behavior, the expansion of credit in the economy, and general economic dynamism.
CPI is the main determinant of central bank interest rate policies

In its various forms (the personal consumption expenditures index (PCE) of the Federal Reserve), the HCPI of the ECB, or the CPI of the BoE, the consumer price index is the main determinant of interest rate policies for central banks of the advanced world. Japan, Britain, Europe, and to an extent, the U.S. all use inflation as the main goal of interest rate policies. Thus, the CPI has some predictive value for the forex and bond markets, as a trend of rising CPI values will eventually lead to the central bank raising rates, and vice versa.

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