Econoday Reports - Consumer Price Index January 18, 2006

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 investor who understands how inflation influences the markets will benefit over those investors that do not understand the impact.

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 indicators 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 as you know the $100 won't be able to buy the same amount of goods and services a year from now. The CPI tells us that prices rose about 4.7 percent a year in the U.S. during the first half of 2006. To recoup your purchasing power, you would have to charge 4.7 percent interest. You might want to add one or two percentage points to cover default and other risks, but inflation remains the key factor behind the interest rate you charge.

Inflation (along with various risks) 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. The effect ripples across stocks, bonds, commodities, and your portfolio, often in a dramatic fashion.

By tracking inflation, whether high or low, rising or falling, investors can anticipate how different types of investments will perform. Over the long run, the bond market will rally (fall) when increases in the CPI are small (large). The equity market rallies with the bond market because low inflation promises low interest rates and is good for profits.

For monetary policy, the Federal Reserve generally follows "core" inflation-inflation excluding volatile food and energy components. The Fed's preferred inflation measure is the core personal consumption deflator but core CPI data largely make up the core PCE deflator and CPI numbers come out sooner each month. In the long run, the overall CPI and core CPI track each other.