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What is the Consumer Price Index (CPI), and how does it affect the markets?

What is the Consumer Price Index (CPI), and how does it affect the markets?

What is the Consumer Price Index (CPI), and how does it affect the markets?

What is the Consumer Price Index (CPI), and how does it affect the markets?

Types of CPI

The BLS regularly produces official CPI estimates based on two population groups – CPI for all urban consumers (CPI-U) and CPI for urban wage earners and clerical workers (CPI-W).

The CPI-U covers almost 93% of the entire US population and is the main report used by the Federal Reserve. As such, when we talk about the CPI in this article, we’ll be pertaining to the CPI-U data.

On the other hand, the CPI-W covers the prices paid by urban wage earners, clerical workers, self-employed individuals, short-term workers, unemployed individuals, and retirees.

How is the CPI market basket determined?

The US Bureau of Labor Statistics (BLS) surveys consumers in private households nationwide as a reference population, collecting information on their spending habits and frequently purchased items. The data collected determines the weight of the item categories in the CPI index structure.

What goods and services are covered by the CPI?

The BLS classified the average American expenditure and consumption patterns into eight major categories.

  1. Housing  
  2. Food and beverages  
  3. Transportation  
  4. Commodities  
  5. Healthcare  
  6. Energy prices 
  7. Education  
  8. Other expenses

The change in price over time for each category is weighed and averaged to create the CPI data.

How is the CPI calculated?

The BLS enlists the help of price collectors to survey over 80,000 price data from 23,000 retail and service establishments throughout the country. They also monitor over 50,000 housing units to calculate the average price changes in rental properties.

Annual CPI = (value of goods and services for the current year/value of goods and services in the previous year) x 100

Let’s look at an example to visualise it further. The price movements below are for illustrative purposes only, and the figures are oversimplified. Let’s assume that this table is the current total expenditure of an average urban consumer for 2021 and 2022.

Below is the formula to calculate the CPI.

Given this calculation, the annual CPI for 2022 is 112.31.

How is the inflation rate calculated from the CPI report?

Inflation is the rise in prices of goods and services. The rate at which prices increase is called the inflation rate.

A steady inflation rate is a significant economic indicator symbolising a country’s economic health. High inflation rates mean prices rise rapidly at the expense of the general public’s purchasing power. A low or negative inflation rate, called deflation, is also negative as the economy has become stagnant.

The Federal Reserve aims to keep the inflation rate at 2% in the US. The Fed uses the CPI published monthly by the BLS to measure inflation. Below is the formula to calculate the US inflation rate:

Inflation rate = (current CPI – previous CPI) x 100

Let’s use the example above to illustrate. Let’s assume that the 2021 CPI is 101.4.

Given this calculation, the inflation rate from 2021 to 2022 is 10.91%. That means the price of consumer goods and services rose by 10.91%.

How does the CPI affect the markets?

The release of CPI data is one of the most anticipated events by traders. It is normal to see volatility in charts before and after the release. However, one thing to note is that traders do not react to the CPI data. Traders react in anticipation of the Federal Reserve’s actions with regard to the CPI report.

The Federal Reserve looks at the CPI report, the Price Producer Index (PPI), and the Personal Consumption Expenditures (PCE) price index to determine whether they should adjust the current monetary policy.

The current mandate of the Federal Reserve is to keep inflation at a steady 2%. Suppose the rate falls below or above this level. In that case, the Fed may implement either an expansionary monetary policy, lowering the interest rates to stimulate the economy or a contractionary monetary policy, increasing interest rates to reduce the money supply in circulation.

To find out how these policies affect the markets, read our article on the Federal Reserve.

Any opinions, news, research, analyses, prices or other information contained on this website is provided as general market commentary and does not constitute investment advice. ThinkMarkets will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
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