Market Analysis
The Consumer Price Index (CPI) is a monthly measure of household goods and service prices in the United States. It measures inflation (increased prices) and deflation (decreased prices). Both can harm a thriving economy.
Definition and an Example of CPI Calculation
Economists use the Consumer Price Index to track price changes in a typical "basket" of products and services purchased by urban consumers. The Federal Reserve monitors pricing changes to guarantee that economic growth is stable. If the Federal Reserve detects excessive inflation or deflation, it will act using monetary policy tools.
The Bureau of Labor Statistics (BLS) calculates the CPI by dividing the average weighted cost of a basket of products in one month by the weighted cost of the same basket in the previous month. It then multiplies the percentage by 100 to calculate the index.
How the CPI Works
The Consumer Price Index (CPI) tracks the prices of various goods and services commonly purchased by urban households, representing approximately 93% of the U.S. population. It utilizes data from a sample of 14,500 families and monitors 80,000 consumer prices.
Housing, referred to as "shelter" by the Bureau of Labor Statistics (BLS), carries the highest weight in CPI calculations. Within housing, the concept of "owner's equivalent of primary residence" (OER) is employed. OER reflects the hypothetical amount homeowners would charge to rent out their homes unfurnished and without utilities.
The BLS conducts annual surveys of homeowners in multiple urban areas to collect this data, rotating one-sixth of the sample each year.
Despite the importance of housing costs, the CPI may underestimate inflation if rental prices remain low despite high home prices. This situation can arise from factors such as decreased rental demand, increased vacancies, and heightened home purchasing activity driven by low interest rates. Consequently, the CPI may not accurately reflect asset inflation, as observed during the housing bubble of 2005.
The CPI includes sales tax. It excludes income taxes as well as investment prices like stocks and bonds.
The CPI tracks two items with extreme price fluctuations: food and energy commodities (oil and gasoline). These products are frequently exchanged on the commodities exchange. Traders might bid prices up or down in response to news such as wars in oil-producing countries or drought. As a result, price fluctuations are frequently reflected in the CPI.
The "core" CPI addresses the issue of unpredictable food and energy prices by omitting them. The Fed has previously examined core CPI when deciding whether to raise the fed funds rate (the interest rate on overnight bank lending). The core CPI is useful since food, oil, and gas prices are volatile, and the Fed's instruments are slow to respond.
How CPI Affects the Fed
The Fed uses the CPI to examine if economic policies need to be changed to prevent inflation.
When it sees that inflation is too high, it implements contractionary monetary policy to halt economic development. It raises the federal funds rate to make loans more expensive, so tightening the money supply (the total amount of credit permitted into the market). Prices fell as growth and demand slowed. This brings the economy back to a healthy growth rate of 2% to 3% annually.
How the CPI affects other government agencies
The CPI is used by the federal government to adjust benefit levels for Social Security recipients and other government financial assistance programs.
How CPI Affects Housing and Investments
Landlords use CPI projections to determine future rent hikes in contracts.
An increase in the CPI might also lower bond prices. Fixed-income assets typically lose value amid inflation. Investors expect higher rates on these investments to compensate for the resulting loss of value.
These yield needs can cause interest rates to rise, increasing the cost of borrowing money for corporate expansion. The net consequence is a drop in earnings, which may weaken the stock market.
Benefits of the CPI
The CPI assesses the rate of inflation, which is one of the most serious risks to a stable economy. Inflation erodes your level of living if your income does not keep up with rising prices; your cost of living rises over time.
A high inflation rate can harm the economy. Everything is more expensive, therefore manufacturers produce less and may be compelled to lay off employees. The CPI allows us to measure these variables.
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