Duration: 7:11
Level: Beginner

The U.S. Consumer Price Index lesson discusses where to find it, how to forecast it, how it’s influenced, and how it influences financial markets and the economy. Inflation can lead to constrained budgets, deteriorating purchase power, and difficulty planning for the future. Tracking the CPI for insights on how fast or slow prices are rising or falling is a critical component of effective economic analysis.

Study Notes:

Prices are important, people care about the relative expenses of everyday goods and services they buy. The consumer price index or CPI represents the change in prices paid by consumers for goods and services. The report provides details on prices paid by consumers for a market basket of goods and services; The goods and services consumers buy the most and pay the most for. For example, shelter, food, medical services, and energy are weighted more heavily in the index since they account for more of consumers’ spending on a regular basis. The CPI is used to adjust many economic series for inflation-free dollars as well as to adjust collective bargaining wages, pricing contracts, along with fixed income from social security and more. Seasonality is a factor as well, since some goods and services like airfares and sporting goods have fluctuating sales and prices throughout the year. The CPI is calculated at the U.S. Bureau of Labor Statistics (BLS) by collecting data from roughly 6,000 randomly sampled households and 22,000 businesses. Data from businesses and households that don’t respond are estimated. The numbers are released within the Consumer Price Index press release during pre-market hours at 8:30am eastern time on or around the 12th day of each month. The BLS measures labor market activity, working conditions, price changes, and productivity in the U.S. economy to aid with both public and private decision making.

Prices are a significant indicator of supply, demand, and the temperature of the U.S. economy. If demand is very high, and supply cannot meet the requirement, price pressures rise as more funds chase fewer goods and services. On the flip side, if demand weakens and supply remains unchanged, price pressures weaken as inventories build up and businesses lower their prices to move goods off of the shelves. Market participants value the year-over-year changes in consumer prices and the month-over month-changes. In addition, they look at the core-CPI which excludes food and energy due to their volatile characteristics. Sometimes food and energy alone can significantly boost the index; therefore, analyzing core CPI and non-core CPI are important in order to understand current price pressure.

An acceleration in consumer prices could make things less affordable and could spiral into longer-term inflationary problems. This could cause the central bank to tighten policy in order to control inflation, keep inflation expectations “anchored” at a desired level and bring the economy back into balance. In the early 1980s, Fed Chair Paul Volcker defeated double digit inflation with contractionary monetary policy that increased interest rates. Demand fell as the cost of financing soared, and price pressures were reigned in, but in exchange the country had to experience a recession.

A deceleration in consumer prices or an outright fall in consumer prices, deflation, could be dangerous and signal weak population growth, weak economic activity or recession. A long-term drop in demand could lead to declining wages, job losses, and large reductions to investment portfolios. In the Great Depression of the 1930s, the U.S. experienced deflation as prices fell hard and fast, while the money supply fell against the backdrop of a central bank that maintained contractionary monetary policy. Unemployment and poverty soared and the stock market crashed. Since then, central banks have been fearful of deflationary episodes and have preferred seeing prices rise in a slow and stable way to accommodate economic and population growth, the Federal Reserve’s target for inflation is two percent.

If inflation rises in the U.S. like it did during the 1970s and early 1980s, tighter policy by the Federal Reserve to control inflation could lead to decreased domestic and global demand. As rates rise to combat inflation, the U.S. dollar could strengthen, making U.S. exports less attractive while making U.S. imports more attractive, and widening the trade deficit. Global U.S. corporations might be impacted negatively as the value of their international sales and profits decrease, due to the currency impacts of a stronger dollar. Emerging market economies that pay back debt in dollars or purchase assets denominated in dollars like crude oil are especially affected as they need to produce more to earn the same level of dollars as in the past. Inflationary episodes that require FED tightening lead to decreases in equity and bond prices.  In addition, a stronger dollar could lead to economic pressures globally, as U.S. economic events ripple globally. Higher inflation in the U.S. means higher inflation around the world.

To forecast CPI, look at the money supply growth to see if more money in the system without commensurate productivity growth risks causing an inflationary episode. Forecasters can look at daily commodity prices since they act as inputs to goods and services, and affect selling prices. Payroll employment, unemployment and wages provide information regarding whether the labor market is tight. Businesses pressured by higher wages can lead to higher and more resistant inflation. Finally, retail sales gauge the temperature of the economy and provide insight as to how hot demand is.

For the average person significant impacts due to inflation include constrained budgets, deteriorating purchase power, and difficulty planning for the future. Inflationary episodes likely lead to recession as central banks need to tighten monetary policy to get rid of inflation and reset the economy. Tracking the CPI for insights on how fast or slow prices are rising or falling is a critical component of effective economic analysis.

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