Around the middle of every month, the Bureau of Labor Statistics issues its Consumer Price Index, known commonly as the CPI. This is an index of prices consumers in urban areas are paying for a specific list, or market basket, of goods and services. The monthly announcement indicates the percent change since the previous month in the average prices of the market basket of goods and services tracked by the CPI. Since it shows the direction of prices, it is considered an indicator of inflation and one of the most important economic indicators. Consequently, the CPI affects stock market trading.
The market basket is made up of more than 200 categories of goods and services, organized into eight groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and miscellaneous goods and services including tobacco and smoking products, haircuts and other personal services and funeral expenses. The CPI also includes taxes that are associated with the purchase of these goods and services as well as government fees such as water and sewerage charges, auto registration fees and vehicle tolls. As a gauge of the cost of living, it gives a good idea of how the consumer's lifestyle is being affected by the prices of common purchases. When the consumer is spending more each month on basics, it is likely he will moderate savings and spending on large-ticket items. This is why the stock market watches the CPI. If the consumer cuts back spending because basic expenses are too high, a recession usually follows and this means lower earnings for public companies and lower prices for their stocks.
Inflation happens when there are too many dollars floating about in the monetary system. When the supply of dollars exceeds the supply of goods to buy, each dollar is worth less, so the prices of those goods increase. It seems logical that corporate revenues would also increase as prices for their goods increase, but corporate expenses also increase. When the Federal Reserve thinks the growth of CPI has been so rapid that it is inflationary, it steps in to raise interest rates and remove money from the system by increasing bank reserve requirements and by selling Treasury securities into the open market. These restrictive Fed actions raise interest rates and restrict the amount of money banks can lend. This, in turn, makes operating a company more expensive and reduces consumer borrowing to buy goods. When companies pull back on their expansion and consumers slow spending, the economy moves into recession and stock prices fall.
Stock prices reflect the market's estimation of future economic growth. When the Fed moves to cool down an overheated economy, it is also temporarily limiting the pace of future economic growth. When this happens, earnings can be expected to decline as business slows. Since each share of stock represents a fractional ownership in the underlying company, if the company's business slows, its earnings per share of stock will decline. Since stock prices are based on earnings per share, the stock prices also fall.
The CPI is the most widely used economic indicator. The Federal Reserve watches it closely to monitor the economy and formulate Fed monetary policy. It also is used to adjust Social Security benefits and other government payments that are geared to follow inflation.
Victoria Duff specializes in entrepreneurial subjects, drawing on her experience as an acclaimed start-up facilitator, venture catalyst and investor relations manager. Since 1995 she has written many articles for e-zines and was a regular columnist for "Digital Coast Reporter" and "Developments Magazine." She holds a Bachelor of Arts in public administration from the University of California at Berkeley.