Prices of goods and services fluctuate over time, but when prices change too muc

h 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 a
re widely anticipated and watched; the CPI plays a role in many key financial de
cisions, including Federal Reserve interest-rate policy and the hedging decision
s of major banks and corporations. Individual investors can also benefit from wa
tching the CPI when making hedging and allocation decisions.

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 i
s available on the BLS's website, and the next release date is on each report.)
The report consists of three indexes representing the expenditures of two popula
tion groups: the CPI for urban wage earners and clerical workers (CPI-W), the CP
I 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 is derived from detaile
d expenditure information collected from thousands of families across the countr
y. 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, medica
l care, recreation, education and communication, and other goods and services. A
lso, the prices of 80,000 items in the market basket are collected monthly from
thousands of retail stores, service establishments, rental units, and doctors' o
ffices.
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 destr
oy an economy if it's allowed to run rampant. Both extreme deflation and inflati
on are feared, though the former is much less common.
We might naturally think of deflation, or falling prices, as a good thing. And t
hey can be--in moderation and within certain limits. The price of phone calls, f
or example, has fallen for more than a century, and it is likely to continue fal
ling with the shift to calls being funneled through the Internet. That's certain
ly not something you'll hear consumers complaining about. But deflation can undo
ubtedly be a bad thing. The best example is the Great Depression, when the legio
ns 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 hyperinflat
ion. 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 mont
h. Hungary printed a 100 million billion Pengo note in 1946. At that point, mone
y really becomes meaningless, and the government must revalue the currency denom
inations: what was once, say, a one-million-unit note then becomes a denominatio
n 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 in
flation rate, but it's still an inflationary condition. And when inflation occur
s 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 doll
ar'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; finally,
employers use the CPI to make wage adjustments that keep up with the cost of liv
ing. Data series on retail sales, hourly and weekly earnings, and the national i
ncome and product accounts are all tied to the CPI to translate the related inde
xes 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 worth less, effectivel
y 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 fix
ed payments. Many retirees have watched their pension payment amounts lose buyin
g 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 con
sumer demand. In this situation manufacturers are forced to drop prices to sell
their products, but the resources and commodities used in production may not fal
l 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 item
s.
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 infl
ation risk. Mutual funds or banks concerned about rising inflation might purchas
e special inflation protected bonds known as TIPS. (You can read more on TIPS in
Inflation Protected Securities - The Missing Link.) Furthermore, the Chicago Me
rcantile Exchange offers futures contracts on the CPI, which can be used to hedg
e inflation. These contracts also provide useful information about the market co
nsensus 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 inf
lation, but outpaced it, earning a positive return. Also, products have been cre
ated to help people tap into this equity that is otherwise illiquid. With a reve
rse mortgage, for example, the owner receives payments, and the property is turn
ed 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 o
ffer no growth component with an annual draw limit, the owner is exposed to infl
ation risk.
Conclusion
The CPI is probably the most important and widely-watched economic indicator, an
d 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 use
d to adjust wages, retirement benefits, tax brackets, and other important econom
ic indicators. It can tell investors some things about what may happen in the fi
nancial markets, which share both direct and indirect relationships with consume
r prices. By knowing the state of consumer prices, investors can make appropriat
e investment decisions and protect themselves by using investment products such
as TIPS.
A consumer price index (CPI) measures changes in the price level of consumer goo
ds and services purchased by households. The CPI is defined by the United States
Bureau of Labor Statistics as "a measure of the average change over time in the
prices paid by urban consumers for a market basket of consumer goods and servic
es."[1]
The CPI is a statistical estimate constructed using the prices of a sample of re
presentative items whose prices are collected periodically. Sub-indexes and sub-
sub-indexes are computed for different categories and sub-categories of goods an
d services, being combined to produce the overall index with weights reflecting
their shares in the total of the consumer expenditures covered by the index. It
is one of several price indices calculated by most national statistical agencies
. The annual percentage change in a CPI is used as a measure of inflation. A CPI
can be used to index (i.e., adjust for the effect of inflation) the real value
of wages, salaries, pensions, for regulating prices and for deflating monetary m
agnitudes to show changes in real values. In most countries, the CPI is, along w
ith the population census and the USA National Income and Product Accounts, one
of the most closely watched national economic statistics.