Skill Level Appropriate for all
- If you accidentally leave a dollar bill in your packet when you do the laundry, it will come out wrinkled and it might be a bit faded but it won't shrink. Now, if you left that dollar bill in your pair of pants for a decade, you'd find that it won't shrink but its purchasing power will. You'll be able to buy less stuff with that dollar due to a general and persistent rise of inflation over time. There are many different measures of inflation and the most important measure is how inflation impacts consumers and one important measure of US consumer inflation is the Consumer Price Index or CPI from the Bureau of Labor Statistics.
The CPI reflects price changes that are watched by executives, central bankers, traders and the media because its changes can affect interest rates, wages and purchasing contracts. Let's take a look at the consumer price index and what's in it especially the two headline figures the media and policy makers watch closely, the total number of inflation which is the blue line in this graph and something called core inflation which is the red line in this graph.
The total CPI includes everything in an average consumer's representative basket of goods, food, energy, clothing, vehicles, medical, shelter and transportation. While total CPI is one headline number to watch, central banks like the Fed also watch something called core inflation which excludes food and energy. This isn't because Fed economists are robots that don't consume food or energy, it's because energy and food prices can see big swings like the rise in gasoline prices after a hurricane or grain prices after a drought and when looking at inflation, you want to remove those swings from your analysis.
Each CPI report is a huge document that comes out monthly and it gets really down to the nitty gritty in terms of cost items like differences in cost measures for pet food versus pet supplies and there's differences between the cost of wine at home and changes in the cost of whiskey at home. And they measure the differences between cookies versus fresh biscuits, rolls and muffins. In all of this data, there may be some categories that matter to you or to your company.
Those are worth watching. I did a research project once for a cookie and biscuit industry group and had to compile and forecast some of this data to help them predict the future of cookie prices and how that might be different than future biscuit prices. Fortunately there's monthly data on this in the CPI report. Companies care a lot about the CPI. Some of my clients make cars and auto parts and these companies use contracts for everything.
They use labor contracts for workers especially when they have unions and they also use purchasing agreements with vendors where they agree to buy certain items at certain prices. Because inflation is a risk, many of these labor contracts and purchasing agreements are tied to the CPI. If inflation goes up, wages for workers go up in a way related to the CPI. And the prices of goods purchased will also go up in a way related to the CPI. By using official government numbers of the most widely cited measure of inflation, the CPI, companies and their workers as well as their vendors can come to terms on what the company will pay if inflation rises.
As someone who is paid to do a certain job, you need to make sure that your wages are rising every year by at least as much as inflation. Otherwise you are technically being paid less to do the same job. A sharp rise of consumer inflation especially core inflation can push a country's central bank to raise interest rates. Higher interest rates can make a currency rise and equities fall while lower interest rates make a currency fall and equities rise.
When inflation goes up, and interest rates rise it can cause a ripple effect across these financial markets. As for you and me, the impact of inflation is simple. When prices rise, the money you and I have is worth less than it was before.