The prices of goods and services fluctuate over time, but when prices change too much and too quickly, the effects can shock an economy. The Consumer Price Index (CPI), the principle gauge of the prices of goods and services, indicates whether the economy is experiencing inflation, deflation or stagflation. The CPI's results are widely anticipated and watched; the CPI plays a role in many key financial decisions, including Federal Reserve interest rate policy and the hedging decisions of major banks and corporations. Individual investors can also benefit from watching the CPI when making hedging and allocation decisions.

TUTORIAL: Economic Indicators

How the CPI Is Constructed
The U.S. Department of Labor's Bureau of Labor Statistics (BLS) releases the CPI data monthly, though the precise date varies from month to month. (A calendar is available on the BLS' website, and the next release date is on each report.) The report consists of three indexes representing the expenditures of two population groups: the CPI for urban wage earners and clerical workers (CPI-W), the CPI for all urban consumers (CPI-U) and the chained CPI for all urban consumers (C-CPI-U).

The base-year market basket, of which the CPI is composed of, is derived from detailed expenditure information collected from thousands of families across the country. The information is collected via interviews and diaries kept by participants. The basket consists of more than 200 categories of goods and services separated into eight groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication and other goods and services. Also, the prices of 80,000 items in the market basket are collected monthly from thousands of retail stores, service establishments, rental units and doctors' offices.

Conditions Illustrated by the CPI
The extensive measures taken to formulate a clear picture of changes in the cost of living helps key financial players get a sense of inflation, which can destroy an economy if it's allowed to run rampant. Both extreme deflation and inflation are feared, though the former is much less common.

We might naturally think of deflation, or falling prices, as a good thing. And they can be--in moderation and within certain limits. The price of phone calls, for example, has been falling for more than a century, and it is likely to continue falling with the shift of calls being funneled through the Internet. That's certainly not something you'll hear consumers complaining about. But, deflation can undoubtedly be a bad thing. The best example is the Great Depression, when the legions of unemployed people couldn't afford to buy goods and services at any price.

When price increases get out of control, inflation is referred to as hyperinflation. The best known example of hyperinflation occurred in Germany in the 1920s, where the inflation rate hit 3.25 million percent a month. Then during World War II, Greece hit 8.55 billion percent a month and Hungary 4.19 quintillion a month. Hungary printed a 100 million billion pengo note in 1946. At that point, money really becomes meaningless, and the government must revalue the currency denominations: what was once, say, a one-million-unit note then becomes a denomination of one unit of whatever the currency may be. Given these historical examples, it's easy to see why any sudden movement in either direction in the CPI can make people very nervous.

There are also several specific types of price fluctuations in the economy, such as disinflation, reflation and stagflation. Disinflation is a slowing of the inflation rate, but it's still an inflationary condition. And when inflation occurs in an economy that isn't growing, the situation is referred to as stagflation, resulting in any inflation being effectively amplified.

Some Uses of the CPI
The CPI is often used to adjust consumer income payments for changes in the dollar's value and to adjust other economic series. Social Security ties the CPI to income eligibility levels; the federal income tax structure relies on the CPI to make adjustments that avoid inflation-induced increases in tax rates and finally, employers use the CPI to make wage adjustments that keep up with the cost of living. Data series on retail sales, hourly and weekly earnings and the national income and product accounts are all tied to the CPI to translate the related indexes into inflation-free terms.

The CPI and the Markets
Movements in the prices of goods and services most directly affect fixed-income securities. If prices are rising, fixed bond payments are worthless, effectively lowering the bonds' yields. Inflation also poses a serious problem to holders of fixed annuities and pension plans, as it erodes the effective value of the fixed payments. Many retirees have watched their pension payment amounts lose buying power over time.

Price volatility can be bad for equities as well. Modest and steady inflation is to be expected in a growing economy, but if the prices of resources used in the production of goods rise quickly, manufacturers may experience profit declines. On the other hand, deflation can be a negative sign indicating a decline in consumer demand. In this situation, manufacturers are forced to drop prices to sell their products, but the resources and commodities used in production may not fall by an equivalent amount. Again, the companies' margins are squeezed due to the stickiness of prices for some items and the elasticity of prices for other items.

Protecting Against Inflation
Fortunately, as the financial markets have become more sophisticated over time, investment products have been created to help even the average person hedge inflation risk. Mutual funds, or banks, concerned about rising inflation might purchase special inflation protected bonds known as TIPS. (You can read more on TIPS in Inflation Protected Securities - The Missing Link.) Furthermore, the Chicago Mercantile Exchange offers futures contracts on the CPI, which can be used to hedge inflation. These contracts also provide useful information about the market consensus for prices in the future.

Also, many people have significant equity in their homes, which is often a good inflation hedge. The investment of many homeowners has not only kept up with inflation, but outpaced it, earning a positive return. Also, products have been created to help people tap into this equity that is otherwise illiquid. With a reverse mortgage, for example, the owner receives payments, and the property is turned over at death. An inheritance may be reduced, but there's a steady stream of income drawn from the equity in the home to fund living expenses. However, this is not necessarily a perfect solution. If the credit options, that are selected, offer no growth component with an annual draw limit, the owner is exposed to inflation risk.

The CPI is probably the most important and widely watched economic indicator, and it's the best known measure for determining cost of living changes--which, as history shows us, can be detrimental if they are large and rapid. The CPI is used to adjust wages, retirement benefits, tax brackets and other important economic indicators. It can tell investors some things about what may happen in the financial markets, which share both direct and indirect relationships with consumer prices. By knowing the state of consumer prices, investors can make appropriate investment decisions and protect themselves by using investment products such as TIPS.

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