7.12: The Market's Reaction

The CPI is eagerly anticipated every month by a host of analysts for many reasons. Let's look at two uses of the CPI that contribute greatly to its impact.

• Deflator: The CPI is used as a deflator (an adjuster) of other economic series. The CPI and its components are used to adjust other economic indicators for price changes and to transform those series' nominal dollars into real, inflation-free dollars. Indicators adjusted by the CPI include retail sales, hourly and weekly earnings, and components of the national income and product accounts.
• Dollar value adjuster: The CPI is often used to adjust consumers' income payments (Social Security, for example), to adjust income eligibility levels for government assistance, and to automatically provide cost-of-living wage adjustments to millions of American workers. CPI affects the income of about 80 million people because of statutory action, including 48.4 million Social Security beneficiaries, about 19.8 million food stamp recipients, and about 4.2 million military and federal Civil Service retirees and survivors. Changes in the CPI affect the cost of lunches for 26.5 million children who eat at school, while collective bargaining agreements that tie wages to the CPI cover more than 2 million workers. The CPI is also used to adjust the federal income tax structure to prevent inflation-induced increases in tax rates, an effect called bracket creep.
• Interest rates: In the U.S., the CPI affects interest rates by influencing inflation expectations. When CPI rises, the Federal Reserve may raise the federal funds rate, increasing borrowing costs for loans, mortgages, and businesses. Higher inflation also pushes up Treasury yields and long-term interest rates. Conversely, when CPI slows, the Fed may lower rates to encourage borrowing and investment.

When the CPI is published, the report releases thousands of detailed statistics to the media. However, the media usually focus on the broadest and most comprehensive, the CPI-U. Some of the data reported are seasonally adjusted, and some are not. Often, the media will report some, or all, of the following statistics:

Statistic	Example
Index level	August 1999 = 167.1
Twelve-month percent change	February 2001 to February 2002 = 1.1 percent
One-month percent change on a seasonally adjusted basis	January 2002 to February 2002 = 0.2 percent
The annual rate of percent change so far this year	If the rate of increase over the first five months of the year continued for the full year, after the removal of seasonal influences, the rise would be 3.0 percent.
The annual rate based on the latest seasonally adjusted one-month change	If the March 2002 to April 2002 rate continued for a full twelve months, the rise, compounded, would be 6.2 percent.

This mock headline is a good example of how economic reporting agencies use several of the statistical methods above to report on the latest CPI numbers:

The CPI rose 0.2% in February, in line with expectations. Over the past year, consumer prices have risen a mere 1.1%, its slowest increase since 1965. This sluggishness has been primarily due to the plunge in energy prices, down 15.6%, and weaker apparel costs, off 3.8%. The Core CPI rose 0.3% in February, a bit higher than expected. Higher apparel and tobacco prices accounted for most of the incremental increase. Over the past year, core consumer prices have increased 2.5%, at the lower end of the narrow 2.5% to 2.8% range they have been in for the last 18 months.

Nearly all markets (consumer, debt, equity, labor, and so on) react in some way to unanticipated changes in the inflation rate. This is mainly due to the strong correlation between the rate of inflation and both long- and short-term interest rates. It is important to realize that interest rates are simply the price, or rental rate, of money. Anything that affects the price of money will have a significant impact on the entire economy. See figure 9.

Figure 9

For example, the debt market (i.e., the fixed-income market) and most of the equity market (i.e., the stock market) react adversely to unanticipated jumps in inflation. Fearing that the Fed will aggressively raise the federal funds rate to slow down the economy and squash inflation, the people holding fixed-income assets such as certificates of deposits (CDs) will want to sell them to avoid being locked into a below-market interest rate. Similarly, those owning stocks might fear that rising prices and interest rates signal that a recession is right around the corner. That would mean that businesses in general would see a fall in sales and profits, which would hurt stock prices and cause many market participants to unload their stocks.