Inflation: The Inside Story

The Bureau of Labor Statistics (BLS) reports the Consumer Price Index each month, on or around the 15^th. Each month's release is based on data compiled in the previous month.

The CPI uses a basket-of-goods approach to predict overall inflation in the economy. The basket of goods includes things like energy (gas, heating oil), food, clothing, electronics and healthcare items. The CPI also adds up the prices on services like entertainment, airline tickets and rent. (To learn more about the CPI release, check out the CPI Tutorial.)

Services make up about 60% of the CPI, while food makes up nearly 15% of the index. There are separate indicators that measure price increases on the producer level (wholesale prices) and the prices of imports, but the consumer prices are most closely watched by economists as they make up the lion's share of economic activity. (for further reading on wholesale prices, check out the PPI Tutorial.)

Mild Inflation
The last CPI release was on November 18 and reflected October data. The headline figure was a seasonally-adjusted 0.3% rise in prices on an annualized basis. This means that if October's results went on for the next year, the total rise would be just 0.3%, a very small rise compared with historical averages. This low level of inflation is why the Federal Reserve feels it can keep short-term interest rates low for quite some time before having to raise them.

Food and Energy Still Volatile
These two components are left out of the most watched CPI figure, the core inflation rate. Food and energy prices tend to be very volatile, so core inflation is considered a way to look at "smoothed out" data.

In October, food prices stayed pretty much the same with just a 0.1% annualized rise, but energy rose on 1.5% annual clip, led by a 6.3% rise in fuel oil. Removing these two put the core CPI at just 0.2% in October, slightly above the Bloomberg consensus estimate of a 0.1% rise.

Every tracking group in the CPI moved less than 2% except for used cars & trucks, which rose 3.4%. Economists feel that this spike was due in large part to the Cash for Clunkers program, which reduced a lot of what would have been used vehicle inventories.

12-Month View
Backing up the camera a bit, the core CPI for the past 12 months rose just 1.7%, far below the 10-year average of 2-2.5%. The CPI measure for rent was flat in October following a small drop in September. These are the lowest readings for rent in nearly two decades, and a big reason why inflation has yet to rear its head in the broad economy.

At this point in the economic cycle, minute inflation levels are to be expected; in a recession there is much more downward pressure on prices. With more people out of work or working fewer hours, there just isn't much discretionary income to go around. Any company that tries to raise prices will simply price themselves out of the market.

Inflation, by contrast, is generally a byproduct of strong growth. When GDP growth starts clicking along, companies feel they can start passing along price increases to consumers.

What Investors Should Take From the CPI
As long as we're seeing positive GDP growth (we had 2.8% in the last quarter) and mild inflation, the environment is good for stocks. Until we see a meaningful spike in the CPI, say a 1.5% annualized rise in future month, investors don't have to fear for Fed rate hikes, which would at least temporarily stall the stock market.

Parting Thoughts
The CPI is by no means a perfect tracking system. There are nearly as many complaints about the CPI as there are data points in the report. But it's the best measure we've got, and when we compare apples to apples – previous CPIs to the current report – the CPI gives us a pretty good overview. Most importantly, the Fed uses the CPI, as do major corporations and our government. So long as GDP growth is rising and the CPI shows only mild inflation, stocks should continue to do well and bond prices should be stable.

To learn more, check out The CPI: A Friend to Investors