Inflation and the Consumer Price Index (CPI)
In general, inflation is the extent to which your money today will buy less in the future. You have probably come face-to-face with inflation at some point in your life. For example, you may have noticed that the price of a movie ticket has gone up, or that the cost of your favorite food items has increased.
Reasons for Inflation
There are many reasons why prices go up:
Inflation can be caused because more people want a particular product. For example, on Valentine’s Day, roses are more expensive because people want to buy them for their spouses and partners.
Inflation can occur when companies raise prices in response to higher costs to make the products they are selling. For example, car prices went up slightly when automobile companies were required by law to include air bags in cars.
Inflation can be caused by planned shortages. For example, if the companies that produce the oil used to make gasoline decide to cut back on the amount of oil they ship to customers, this could increase the price of oil, and in turn the price of gasoline.
Inflation can be caused by fear of shortages. For example, during a war, certain items such as gasoline may go up in price because people are scared their supplies will be cut off, and so they start to hoard it.
Inflation as Measured by the Consumer Price Index
The Consumer Price Index for All Urban Consumers, or CPI-U, is one measure of inflation used by the government. The U.S. Labor Department produces the monthly CPI-U, which measures the increase in the price of a given “basket” of goods and services purchased by typical consumers. It covers a large number of items, including food, housing, apparel, transportation, medical care, and entertainment. The CPI-U often is used to increase or adjust payments for rents, wages, alimony, child support and other obligations that may be affected by changes in the cost of living.
A very simplified example of how the CPI-U calculation works is that prices are added together for the typical items people buy, and this sum is compared to the same “basket” of goods a year later. For example, a basket of goods could include things like milk, gas, meat, rent, clothes, and other things essential for everyday life. Adding up the prices of these items one year and adding up the prices a year later can tell you whether prices are moving up or down. The percentage increase in price for these goods will be the rate of inflation. Of course, prices can also go down, too, in which case you’ve got deflation.
Inflation is given in percentage terms based on the changes to CPI-U. For example, one way to calculate the inflation rate in 2015 is to compare the December CPI-U figures in 2014 and 2015. These figures were $234.812 in December 2014 and $236.525 in December 2015. You can roughly calculate the point-in-time inflation rate (from December to December) in percentage for 2015 as follows:
(CPI-U in 2015 - CPI-U in 2014) × 100 / (CPI-U in 2014) =
($236.525 - $234.812) × 100 / $234.812 = 0.73%
You can also calculate the average inflation in 2015 by using the average CPI-U in 2014 and 2015 in the formula above. The average CPI-U figures in 2014 and 2015 were $232.957 and $236.736, respectively. You can roughly calculate the average inflation rate in percentage for 2014 as follows:
(CPI-U in 2015 - CPI-U in 2014) × 100 / (CPI-U in 2014) =
($237.017 - $236.736) × 100 / $236.736 = 0.12%
When you see the inflation rate quoted in the media, you have to find out whether the writer or reporter is referring to the average annual inflation rate as calculated in the example above, or a point-in-time inflation rate such as in the prior example. Nevertheless, you can do your own calculation by accessing government CPI-U data.
This data consists of CPI-U and inflation rate information going back to 1913. At the time of this writing, the highest average annual inflation rate based on the CPI-U was 17.80% in 1917, and the lowest was negative 10.85% in 1921.
Pitfalls of a Low Inflation Rate
A very low inflation rate may actually indicate that the economy is not doing very well. For example, in 2009, after the worst financial crisis the United States has faced since the Great Depression, the average inflation rate was -0.34%. This was a sharp decline from the 2008 average inflation rate of about 3.85%. Such a steep decline generally indicates that the economy is in deep trouble. One way the government tries to maintain healthy rates of inflation and economic growth is to change an interest rate called the discount rate to affect how much money people borrow and spend.
A 2015 article by The Boston Globe, written when the Federal Reserve Bank was contemplating whether to raise interest rates, explains the negative side of low inflation as follows:
The idea that inflation can be too low is difficult for many people to get their heads around, particularly older Americans, who have watched the Fed fight rising inflation for most of their lives. But some inflation — the Fed says about 2 percent a year — is the sign of a healthy economy, translating into rising wages, appreciating assets, and stronger growth, as well as higher prices. But inflation at the consumer level has been nonexistent in recent months; in July it rose at annual rate of just 0.2 percent, according to the Labor Department. Other economic conditions, including a weakening global economy and falling crude oil prices, suggest inflation will remain low for a while.
How Inflation Affects the Stock Market
To understand how inflation affects the stock market, you first have to understand what determines stock prices of the companies traded on the various exchanges we discussed earlier. The stock price of a company depends on how much that company is expected to make in the future. To make it perfectly clear, net earnings (also known as net income and net profit) drive a company’s stock price. In other words, the more you expect a company to earn in the future, the higher the value of the company’s stock.
If inflation is high, a company’s earnings in the future are worth less and less. That’s because what the company earns in the future won’t buy the same things it can buy today. If a company’s expected earnings are worth less in the future, then its stock price will go down. Therefore, in general, the higher the inflation, the worse things are for the stock market.
To show you a real example of how the inflation rate (as reflected in the consumer price index) affects the stock market, here is an excerpt from a 2000 article in The Wall Street Journal:
Stocks plunged, with the major indexes enduring their biggest point drops ever and among their steepest percentage losses in a decade. Friday’s consumer-price report indicated that inflation was resurfacing. The Nasdaq Composite Index dropped 355.49 points, or 9.7%, to 3321.29. The Dow Jones industrials sank 617.78 points to 10,305.77.
This passage above was referring to one of the biggest-ever point drops in the market – for both the Dow and the NASDAQ – which occurred on Friday, April 14, 2000. This drop was caused primarily by a consumer price index report, which showed that inflation jumped by 0.7%.
How Inflation Affects the Interest Rate
Inflation also affects the interest rate – what you pay to borrow money. The higher the inflation rate, the higher the interest rate. This is because lenders want to make up for the fact that the higher inflation will make the interest borrowers pay to them worth less and less. So, to make up for these losses, they have to increase the amount of interest they charge.