What is the Consumer Price Index and how to trade it?

The Consumer Price Index (CPI) is a measure of the average change over time in the prices consumers pay for a basket of goods and services. It is calculated by the Bureau of Labor Statistics (BLS) as their measure of inflation. It is typically released around the second Wednesday of each month and refers to the previous month.

What is CPI?

The index is calculated using the prices of a fixed basket of goods and services, with the base period prices set to 100. To determine the index for the current period, prices are compared to prices in the base period. The percentage change in the index since the base period is then used to measure inflation.

The Consumer Price Index (CPI) tracks price changes for a set of goods and services. The basket includes categories such as food and beverages, housing, clothing, transportation, medical care, recreation, education, communications, and other items. The Bureau of Labor Statistics (BLS) periodically updates this market basket to reflect changes in consumer spending patterns.

What impact does CPI have on financial markets?

The CPI can affect monetary policy, interest rates, and the value of the currency. It also affects wages, consumer spending, and economic growth. High inflation can lead to economic instability, while low or negative inflation (deflation) can indicate a weak economy.

1. Interest rates and monetary policy
The Consumer Price Index (CPI) is a key economic indicator that influences the Federal Reserve’s interest rate decisions. When inflation is high (as indicated by a rising CPI), the Fed can raise interest rates to cool the economy. On the other hand, low inflation can prompt the Fed to lower interest rates to stimulate economic growth. Fluctuations in interest rate expectations due to the CPI data can affect bond and stock prices as investors adjust their forecasts.

2. Bond markets
The Consumer Price Index (CPI) has a significant impact on bond yields (as illustrated by the red line in the chart below). Higher inflation often leads to higher yields as investors expect more compensation for the reduced purchasing power of future bond payments. As the CPI rises, demand for Treasury Inflation-Protected Securities (TIPS) can also increase because these securities provide a hedge against inflation.

3. Stock markets
Inflation affects corporate profits by raising costs for companies, which can squeeze profit margins if they are unable to pass on those costs to consumers. Different sectors respond to inflation differently: consumer discretionary and utilities may outperform in high-inflation environments because of the ability to pass on costs to consumers, while growth sectors like technology may struggle because of higher discount rates on future profits.

4. Currency markets
Higher inflation can cause a currency to fall in value as purchasing power decreases. However, if inflation causes interest rates to rise, the currency may appreciate due to increased demand for higher-yielding investments. Currency traders closely monitor CPI data to forecast central bank policy and make informed trading decisions.

5. Commodity markets
Commodities such as gold and oil are very sensitive to inflation data. Gold is often seen as a hedge against inflation, so rising CPI data can increase demand for gold. Inflation can also affect oil prices both directly, through increased production costs, and indirectly, through changes in monetary policy. Since oil is a key factor in transportation, higher oil prices can lead to higher transportation costs, which affects commodity prices. In addition, higher oil prices can lead to higher producer prices, which can prompt workers to demand higher wages.

When considering trading and predicting the prices of shares, indices, currencies (forex) and commodities, you should remember that trading CFDs carries a significant degree of risk and can result in the loss of your capital.

Past performance is not a guide to future results. This information is provided for informational purposes only and should not be construed as investment advice.