Definition
The Consumer Price Index is a measure of the average price level of a fixed basket of goods and services purchased by consumers. Monthly changes in the CPI represent the rate of inflation.
Why Do Investors Care?
The consumer price index is the most widely followed indicator of inflation in the United States. An individual investor who understands the process of inflation and how inflation influences the markets will no doubt benefit over those investors that do not understand the consequences of inflation.
Inflation is an increase in the overall prices of goods and services. The relationship between inflation and interest rates is the key to understanding how data such as the CPI influence the markets - and your investments.
If someone borrows $100 dollars from you today and promises to repay it in one year with interest, how much interest should you charge? The answer depends largely on inflation, because you know that the $100 won't be able to buy the same amount of goods and services a year from now, as it does today. If you were in a country where prices doubled every couple of months, you might want to charge 400% interest for a total payoff of $500 at the end of the year. In the United States, the CPI tells us that prices were rising about 3 to 3.5 percent a year through the summer of 2005. Consequently, you would have to charge 3 to 3.5 percent interest simply to recoup your purchasing power within the next 12 months. You might want to add in one or two percentage points to cover default risk and the opportunity cost, but inflation remains the key variable in what interest rate you would charge.
Inflation (along with default risk and opportunity cost) basically explains how interest rates are set on everything from your mortgage and auto loans to Treasury bills, notes and bonds. As the rate of inflation changes and as expectations on inflation change, the markets adjust interest rates accordingly. The effect ripples across stocks, bonds, commodities, and your portfolio, often in a dramatic fashion.
By tracking the trends in inflation, whether high or low, rising or falling, investors can anticipate how different types of investments will perform.
