(Prosperity - Jason Drill)
Jason Drill has spent the last ten years working in the investment banking and financial education industries. How well does he know his stuff? Deutsche Bank distributed a proprietary valuation and acquisition financing model he built to over 800 managers globally. He's joined prosperity to help demystify finance for the rest of us.
What the heck is the CPI and why should I care?
The Consumer Price Index (that is, “CPI”) is a monthly statistic, released by the Labor Department’s Bureau of Labor Statistics, meant to track our country’s inflation rate. Inflation is the rate at which the prices for goods and services are increasing over a beginning benchmark value and time.
Before I get into the CPI details, let me explain why this one of the more important economic statistics published. Inflation affects not only everything you purchase from that new iPhone 3G to the frozen vegetable medley bought on a whim to eat better now growing icicles in the back of the freezer, but also the assets that you hold, including savings accounts, stock and bond investments and real estate.
We all have a sense of inflation when we shop and recall what those same items cost just last year or even earlier. Of course as we get older, this turns into, “I remember when a can of Coke was only 25 cents!” This price change is usually a function of inflation, although some other factors may be involved.
Inflation is basically continuously falling value of money. Right, it says inflate, but that’s kind of cruel tease. If your personal savings plan entails hiding a portion of the monthly paycheck under your mattress or in the closet, inflation will devalue that cash as it sits there waiting to be used. Inflation of 10% will make a dollar today “worth” only 90 cents a year from now. Unless you earn something on your hard-earned money, you won’t “keep up” with inflation.
Almost all investment products are reported in terms of gross returns or interest rates, not reflecting inflation. So when inflation numbers get reported every month, institutional investors immediately adjust their future expectations of inflation and may change their investment decisions. Two-year treasury notes yielding 3% will look much worse if your inflation expectation over those two years increases from 1% to 2%. This kind of analysis is happening across all assets classes and with varyng complexity.
High inflation creates a lot of uncertainty not only for investment decisions but also for corporate business decisions. The Federal Reserve is constantly worried about the effects of inflation on long-term economic growth and tries to temper it through its control of bank borrowing rates. Generally the Federal Reserve will increase interest rates to try and lower inflation through slower economic growth in the short term. In 2008, that has been made difficult by a combination of slowing growth and still rampant inflation.
The most publicized measure of past inflation that we have is the CPI. The CPI is reported as an index number based on a starting benchmark a benchmark of 100 created during the reference period consisting of a 36-month span from 1982 to 1984. The percent change in the CPI index year over year and month over month is what is most often reported by the mainstream media.
With the CPI, the Bureau of Labor Statistics (“BLS”) is trying to accurately measure inflation as experienced by urban consumers in their day-to-day living expenses. The BLS uses a basket of goods reflecting family buying patterns determined during a two year survey. This basket is arranged into eight major categories:
- Food and Beverages
- Housing
- Apparel
- Transportation
- Medical Care
- Recreation
- Education and Communication
- Other Goods and Services
The BLS makes substitutions and readjustments in weight over time to try and reflect the true cost of living with changes in consumer purchasing decisions. This “cost of living” methodology, which was introduced in 1999, has been criticized by some investment professionals as not truly reflecting the “cost of goods” inflation that consumers are actually experiencing. Their argument is that with benefits for such large government programs as social security and food stamps escalating with the CPI, it is in the government’s interest to keep the reported CPI as low as possible.
Regardless of accuracy, the CPI number is something easily accessible and important to follow for your own financial health. With each (ahem, frequent or at least more so than the dentist, please) financial checkup, be sure to review the recent CPI numbers and make sure your investments will keep you in great shape.
