What Is the CPI, and How Does It Affect the Stock Market?

When building your trading strategies, you may have heard other traders, companies, and the news mention the CPI. But what is it? To help you understand, we will explore this financial tool and how it may impact the stock market.

We're taking a look into:

• What is the CPI

• How the CPI is calculated

• How the CPI is used

• How the CPI can affect the stock market

Let's get started so you can figure out if this indicator will work with your trading strategy.

What is the CPI

The Consumer Price Index (CPI) is used to measure the change in prices paid by consumers in the US each month. This number is calculated as a weighted average by the Bureau of Labor Statistics (BLS), using the prices for a basket of goods and services that represent a typical collection a US consumer would purchase. The BLS publishes two types of CPIs — one for urban consumers (CPI-U) and another for urban wage earners and clerical workers (CPI-W).

The CPI uses different price samples, index weights, and survey techniques from the producer price index (PPI), which helps calculate the prices that US producers are paid for goods and services.

How the CPI is calculated

To determine the CPI, the BLS collects the prices for goods and services for approximately 94,000 items from around 23,000 retail and service providers. The more widely used version of the CPI, the CPI-U, accounts for the average of prices that nearly 93% of the US population would be facing.

Making up nearly one-third of the overall CPI is the cost of housing. Under the shelter category, prices are averaged based on a survey of rents for approximately 43,000 housing units. This number is used to determine the increase in rental costs in addition to owner equivalents.

While there is a phenomenon known as substitution effects — when consumers shift to less expensive brands and categories that have not increased in price rapidly — the CPI takes this facto into account. In addition, the index adjusts data on pricing, providing weighted values for different quality and features of products.

How the CPI is used

There are a number of entities that use this measure to make informed decisions.

The Federal Reserve

To help determine economic policy, the Fed uses data from the CPI. If the market slows, it can enact policy that can help stimulate the economy. If market growth slows, the Fed can take the opposite tactic to prevent prices from rising too quickly as a result of economic growth. If inflation rises above the target inflation rate of 2%, the Fed can adjust the Fed funds rate.

It is important to remember that the CPI has faced criticisms for understating or overstating inflation. The measurement is based on consumer spending. Therefore, it doesn't reflect third-party reimbursements and underweights health care in relation to the GDP.

Other Government Agencies

Using the CPI, other government agencies will make cost-of-living adjustments. These adjustments impact federal pensions, income tax brackets, and subsidies for school lunches, as well as nearly 70 million US citizens who receive Social Security and Supplemental Security Income (SSI).

Housing

To combat rising inflation, mortgage rates and other types of long-form debt are often directly impacted by inflation. Government agencies may enact policies to slow inflation by raising interest rates. Landlords can also use CPI to determine how much is appropriate for annual rent increases.

Labor Markets

The CPI and its components are also used as a deflator for other economic indicators, including retail sales and hourly/weekly earnings, to separate fundamental change from that reflecting change in prices.3 Employees may turn to CPI reports when approaching their employers for a raise based on nationwide increases to labor rates as well as pricing.

Be mindful that the CPI is published using national data; employees may be more suited to using local data to better understand their specific situation. In addition, some workers covered by collective bargaining agreements may have their wages tied to changes in CPI.

How the CPI impacts the stock market

While the stock market is influenced by a myriad of factors, the CPI can significantly influence swings in performance. For instance, reactionary Fed moves can directly impact corporate profits and economic growth, leading the stock value to fluctuate drastically. Higher Fed rate hikes based on CPI often cause the market to dip or slow as traders want to hedge their bets.

CPI as an indicator for trading

When inflation poses a risk to economic growth, impacting the prices of a number of securities, traders can attempt to curb risks by investing in securities that benefit from inflation. One example is Treasury Inflation-Protected Securities sold by the US government that don't face value erosion for future interest payments because their coupon payments are adjusted based on the CPI.

Advanced investors may also purchase an inflation swap. With this strategy, a trader purchases a derivatives contract that allows for payments that are based on CPI changes.

Key Takeaways

While the CPI is not a foolproof market indicator, it is still a very popular metric and a financial factor to consider. Because it is based on average consumer spending, it helps highlight signs of inflation. The CPI is also an important indicator to look for when building trading strategies, as a significant increase in consumer spending can indicate increased inflation and a chance of a market downtrend. There are inflation-protected securities as well as derivatives contracts that traders can consider to help manage their risks.

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Sources: https://www.bls.gov/cpi/overview.htm

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Any illustrations, scenarios, or specific securities referenced herein are strictly for illustrative purposes. Past investment performance does not guarantee future results. Investing involves risk and the potential to lose principal.