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Lesson 22: CONSUMER PRICE INDEX (CPI)

The second type of inflation indicator, the Consumer Price Index (CPI), has far greater bearing on the choices of policy makers (such as the US Federal Reserve), and the market in general attaches to it a far greater degree of significance than the PPI. The CPI, as a measure of living costs, has a direct bearing on interest rates, and eventually, the timing of growth cycles (in other words, booms and busts).

The consumer price index measures price changes at the retail level. It registers the price fluctuations only to the extent that a retailer is able pass them on to the consumer. Thus, in an environment of high competition and falling or low demand growth, the retailer may have to cut on his profits, and a rise in PPI may not be reflected in the price the consumer pays, as measured by the CPI.

HOW TO INTERPRET CONSUMER PRICE INDEX NUMBERS

Rising CPI signifies high inflation, and central banks in general have the goal of keeping inflation low but positive, so that the consumers’ purchasing power is not eroded.

A rising, but slowing CPI defines disinflation: Prices are still growing, but the speed and intensity of price increases is slowing.

Finally, a negative CPI implies deflation: A situation which often suggests that demand across the board is contracting, and the consumer can simply choose to wait for as long as he can before he buys a product. The longer he waits, the lower the price becomes.

It may sound complicated, but the beginning trader will do well by just keeping in mind the relationship between central bank interest rates and the CPI: higher CPI leads the central banks to raise rates, and as higher rates mean higher yield, the currency with high interest rates backing it tends to appreciate. Lower or falling CPI means that inflation risks have receded, corresponding to lower growth, and the central bank is free to lower rates to boost growth.

The CPI is also released monthly by the BLS (Bureau of Labor Statistics).

KEY POINTS

  • The consumer price index measures price changes at the retail level, the prices paid by consumers.
  • The CPI is the second major measure of inflation, along with the producer price index (PPI)
  • CPI is less volatile than PPI, as it only measures prices changes that are passed onto consumers
  • Rising CPI indicates growing inflation. Central banks aim to keep inflation low.
  • A rising, but slowing CPI defines disinflation – prices are still growing but not as quickly.
  • A negative CPI implies deflation, a situation where demand is dropping and prices are falling.

FURTHER READING

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