What is CPI inflation and why does it matter?

VaselineOctober 10, 2024

0 3 minutes read

What is CPI inflation and why does it matter?

What just happened?

US consumer price index (CPI) inflation rattled markets in September, with headline CPI inflation falling less than expected on an annual basis and core CPI inflation climbing higher over the same period. Investors had generally hoped that US inflation figures would continue to fall towards the Federal Reserve’s (Fed) annual inflation target of 2%, but September’s CPI inflation weighed on jittery markets, taking the legs out from under the market’s risk appetite.

Why does CPI inflation matter?

CPI inflation is a measure of the month-to-month change in consumer-level prices for a mixed basket of consumer goods that represents a significant cross-section of the overall consumer economy. While the CPI index lacks consumer price information for rural residents, measuring only changes in the costs of urban goods, the CPI index as a broader measure of consumer inflation captures approximately 93% of the US population.

Because controlling inflation through interest rates is half of the Fed’s mandate (the other half being stable employment, a unique feature of the Federal Reserve not shared by other central banks), CPI inflation is used by markets as a key estimation method . when the Fed will make changes to the Fed funds rate and by how much. With inflation continuing to exceed the Fed’s target levels, increases in key inflation metrics make it difficult for the Fed to cut rates as quickly or as furiously as investors would like.

What happens next?

With CPI inflation coming in higher than expected in September, investors will turn to the rest of the economic data file for signs of weakness that could spur the Fed back into a faster pace of rate cuts until the end of the year. The weakness in the labor market was seen as a likely flashpoint for further, larger-than-expected rate cuts. However, too much in the red on jobs data or other inflation metrics (such as the Personal Consumption Expenditure Price Index) could also raise fears of a widespread recession in the economy US, leaving investors in a challenging ‘gold rush’ position: Markets are hoping for weakness in the US economy to force the Fed to cut interest rates, but an outright slide into recession will make rate cuts a moot point.

Economic indicator

Consumer price index excluding food and energy (annual)

Inflationary or deflationary trends are measured by periodically summing the prices of a basket of representative goods and services and presenting the data as the Consumer Price Index (CPI). CPI data is compiled monthly and published by the US Department of Labor Statistics. The YoY reading compares commodity prices in the reference month to the same month a year earlier. CPI Ex Food & Energy excludes the so-called more volatile food and energy components to provide a more accurate measurement of price pressures. Generally, a high reading is bullish for the US dollar (USD), while a low reading is considered bearish.

Fed FAQ

Monetary policy in the US is shaped by the Federal Reserve (Fed). The Fed has two mandates: to ensure price stability and to promote full employment. Its main tool for achieving these objectives is the adjustment of interest rates. When prices rise too quickly and inflation is above the Fed’s 2 percent target, it raises interest rates, raising borrowing costs throughout the economy. This results in a stronger US dollar (USD) as it makes the US a more attractive place for international investors to park their money. When inflation falls below 2% or the unemployment rate is too high, the Fed can lower interest rates to encourage borrowing, which hurts the greenback.

The Federal Reserve (Fed) holds eight policy meetings a year, where the Federal Open Market Committee (FOMC) assesses economic conditions and makes monetary policy decisions. Twelve Fed officials attend the FOMC—the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four of the remaining eleven regional Reserve Bank presidents, who serve rotating one-year terms. .

In extreme situations, the Federal Reserve can resort to a policy called Quantitative Easing (QE). QE is the process by which the Fed substantially increases the flow of credit in a stuck financial system. It is a non-standard policy measure used during crises or when inflation is extremely low. It was the Fed’s weapon of choice during the Great Financial Crisis of 2008. It involves the Fed printing more dollars and using them to buy higher quality bonds from financial institutions. QE usually weakens the US dollar.

Quantitative tightening (QT) is the reverse process of QE, whereby the Federal Reserve stops buying bonds from financial institutions and does not reinvest the principal of bonds it holds at maturity to buy new bonds. It is usually positive for the value of the US dollar.

VaselineOctober 10, 2024

0 3 minutes read