Last Updated on October 11, 2023
Understanding the Consumer Price Index (CPI) and how to calculate it can help determine the cost of living in a particular country. It can also provide a general overview of the health of the economy, which can be helpful to traders and investors. In this article, we will cover the following:
Introduction
The CPI is among the most important macroeconomic indicator tools in an investor’s arsenal. Using the Consumer Price Index Formula to track how the costs of goods and services are continuously changing helps get a better read on how the economy is performing. In turn, this provides valuable insight into the state of the financial markets.
There is a strong positive relationship between economic growth and financial market development. And while they are not always directly related, a thriving economy often bodes well for the financial markets.
Futures and options traders can also greatly benefit from knowing how to calculate CPI. This is because the CPI helps measure inflation, which significantly impacts markets. For example, gold is a popular instrument to hedge inflation, so the rise or fall of inflation in an economy can help traders identify opportunities in the gold futures and options markets.
What is the Consumer Price Index?
Sometimes called „the cost-of-living index,“ the CPI is a measure of the average changes in prices for a market basket of consumer goods and services over a given period. This basket comprises everyday necessities, such as food, shelter, clothing, medical care, and transportation. In the U.S., as an index, the CPI tracks the expenditure pattern of American households and is usually computed monthly, quarterly, or yearly.
The Consumer Price Index is the most popular measure of the inflation rate and the cost of living in a country. As such, it is constantly monitored by policymakers, financial market participants, businesses, and even individual consumers. With the periodic release of CPI reports, these stakeholders can analyze the change in the prices of individual goods and services and the changes in the average price of the market basket. The inflation rate is the average rate by which market basket price changes over time.
The CPI is also the basis for calculating the cost-of-living adjustment (COLA). COLA represents the increase of the Social Security and Supplemental Security Income (SSI) to compensate for inflation over a particular period. Essentially, the COLA helps households maintain a reasonable living standard.
Who Calculates the CPI?
The U.S. Bureau of Labor Statistics (BLS) is responsible for tracking and computing the CPI. It was first calculated in 1917 when World War I and its toll on global economies led to an abnormal price surge. This created the need for an index to measure how quickly the cost of essential goods and services was changing.
How the CPI Market Basket is Determined
To calculate the CPI, the BLS surveys 24,000 households across the United States. It acquires data based on where families shop regularly and the most common types of goods and services they purchase. It also surveys around 21,000 retail businesses across major metropolitan areas to acquire pricing information for tens of thousands of consumer items.
All of this information is collated and analyzed to form the CPI market basket.
| Mar. 2022 | Apr. 2022 | May 2022 | Jun. 2022 | Jul. 2022 | Aug. 2022 | Sep. 2022 | Un-adjusted 12-mos. Ended Sep. 2022 | |
| All Items | 1.2 | 0.3 | 1.0 | 1.3 | 0.0 | 0.1 | 0.4 | 8.2 |
| Food | 1.0 | 0.9 | 1.2 | 1.0 | 1.1 | 0.8 | 0.8 | 11.2 |
| Food at home | 1.5 | 1.0 | 1.4 | 1.0 | 1.3 | 0.7 | 0.7 | 13.0 |
| Food away from home | 0.3 | 0.6 | 0.7 | 0.9 | 0.7 | 0.9 | 0.9 | 8.5 |
| Energy | 11.0 | -2.7 | 3.9 | 7.5 | -4.6 | -5.0 | -2.1 | 19.8 |
| Energy commodities | 18.1 | -5.4 | 4.5 | 10.4 | -7.6 | -10.1 | -4.7 | 19.7 |
| Gasoline (all types) | 18.3 | -6.1 | 4.1 | 11.2 | -7.7 | -10.6 | -4.9 | 18.2 |
| Fuel oil | 22.3 | 2.7 | 16.9 | -1.2 | -11.0 | -5.9 | -2.7 | 58.1 |
| Energy services | 1.8 | 1.3 | 3.0 | 3.5 | 0.1 | 2.1 | 1.1 | 19.8 |
| Electricity | 2.2 | 0.7 | 1.3 | 1.7 | 1.6 | 1.5 | 0.4 | 15.5 |
| Utility (piped) gas service | 0.6 | 3.1 | 8.0 | 8.2 | -3.6 | 3.5 | 2.9 | 33.1 |
| All items less food and energy | 0.3 | 0.6 | 0.6 | 0.7 | 0.3 | 0.6 | 0.6 | 6.6 |
| Commodities less food and energy commodities | -0.4 | 0.2 | 0.7 | 0.8 | 0.2 | 0.5 | 0.0 | 6.6 |
| New vehicles | 0.2 | 1.1 | 1.0 | 0.7 | 0.6 | 0.8 | 0.7 | 9.4 |
| Used cars and trucks | -3.8 | -0.4 | 1.8 | 1.6 | -0.4 | -0.1 | -1.1 | 7.2 |
| Apparel | 0.6 | -0.8 | 0.7 | 0.8 | -0.1 | 0.2 | -0.3 | 5.5 |
| Medical care commodities | 0.2 | 0.1 | 0.3 | 0.4 | 0.6 | 0.2 | -0.1 | 3.7 |
| Services less energy services | 0.6 | 0.7 | 0.6 | 0.7 | 0.4 | 0.6 | 0.8 | 6.7 |
| Shelter | 0.5 | 0.5 | 0.6 | 0.6 | 0.5 | 0.7 | 0.7 | 6.6 |
| Transportation services | 2.0 | 3.1 | 1.3 | 2.1 | -0.5 | 0.5 | 1.9 | 14.6 |
| Medical care services | 0.6 | 0.5 | 0.4 | 0.7 | 0.4 | 0.8 | 1.0 | 6.5 |
It’s important to note that there is a time lag between the survey and when Consumer Price Index market basket is formed. For example, the CPI market basket used in 2021 was likely based on data collected from surveys conducted in 2018. This doesn’t mean there’s a lag in the CPI itself, but rather that the market basket used in the CPI calculation lags by a few years.
Whose Spending Patterns Does the CPI Reflect?
The CPI tracks the buying habits of two primary population groups:
● Urban consumers — this group represents about 93% of the total U.S. population and is based on the spending of urban residents, including self-employed individuals, professionals, retirees, and the unemployed. It excludes the spending patterns of people living in rural areas, Armed Forces members, prisoners, and patients in mental institutions. Consumer inflation for this group is known as the Consumer Price Index for All Urban Consumers (CPI-U).
● Urban Wage Earners and Clerical Workers — this group represents the aggregate spending of households included in the CPI-U definition plus two additional requirements. First, over 50% of the household’s income must come from clerical or wage occupation. The second requirement is that at least one of the household’s primary earners must have been employed for a given period. The CPI for this group is known as the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). It represents about 29% of the total U.S. population.
How to Calculate the CPI Formula
The value of the CPI is expressed as a percentage and represents how the cost of the same goods and services has changed compared to a base period. The BLS maintains records dating as far back as the early 1900s but uses the 1982-84 baseline to measure inflation.
This baseline sets the index level at 100, which is then used to compare against the current rate. For example, an index of 147 means that there’s been a 47% rise in the market basket price over time. Similarly, an index of 84 indicates a 16% (100 – 84) decrease in the market basket price.
When calculating the price index, there are three different CPI formulas that can be used:
1. Laspeyres Price Index
Developed by German economist Etienne Laspeyres, this price index measures the change in the prices of a basket of goods and services using weights taken from a specific base period.
The CPI Formula for calculating the Laspeyres Price Index, or CPI(L), is as follows:
CPI(L) = ∑ [p(c) x q(b)] / ∑ [p(b) x q(b)]
Where:
p: Item price
q: Item quantity
b: base time period
c: current time period
2. Paasche Price Index
The Paasche Price Index was invented by Hermann Paasche, also a German economist. It measures the change in the price and quantity of a market basket of consumer goods and services using weights taken from the current period.
The CPI Formula for calculating the Paasche Price Index, or CPI(P), is as follows:
CPI(P) = ∑ [p(c) x q(c)] / ∑ [p(b) x q(c)]
The legend is the same as the one for the Laspeyres Price Index, as listed above.
3. Fisher Price Index
Also known as the Fisher’s Ideal Price Index, this CPI Formula is calculated based on the geometric average of the Laspeyres and the Paasche price indexes. It is considered to be a more “ideal” price index. That’s because, by using a geometric mean of the two weighted indices, it corrects the negative price bias in the Paasche Price Index, as well as corrects the positive price bias in the Laspeyres Price Index.
The CPI Formula for calculating the Fisher Price Index, or CPI(F), is as follows:
CPI(F) = √ [CPI(L) x CPI(P)]
These CPI calculations provide the ratio between the prices of the market basket of the current period and the base period. The value is then multiplied by 100 to express the ratio in percentages.
Calculating the Inflation Rate Using the CPI
The percentage change of the price index represents the inflation rate.
The formula for calculating the inflation from the CPI is as follows:
Inflation Rate = [CPI(c) – CPI(b)] / CPI(b)
Where CPI(c) is the Consumer Price Index in the current period, and CPI(b) is the Consumer Price Index in the base period.
By calculating the inflation rate, financial market participants can get an idea about future interest rate changes. For example, in the United States, if there is an abrupt deviation of the Consumer Price Index from the Federal Reserve’s inflation target, the financial markets would expect the Fed to intervene by raising or lowering the interest rate level. Investors and traders will factor this expectation into their decision-making about what positions to open or close.
Trading the Consumer Price Index
This primarily involves trading with CPI data releases. Understanding CPI data is essential to traders because it is a leading indicator of inflation. As you already know, inflation significantly influences a country’s interest rates and, by extension, its economy.
Often, higher inflation will result in policymakers setting higher benchmark interest rates to curb inflation. Among other things, raising interest rates discourages borrowing, which in turn can lower aggregate demand, forcing the prices of consumer goods and services to come down.
On the flip side, lower inflation often sees policymakers lowering benchmark interest rates to encourage borrowing and improve aggregate demand. This effectively pushes the prices of consumer goods and services up.
Higher interest rates can also strengthen the country’s currency, making it more attractive in the Forex market. Conversely, a country with low-interest rates may result in having a weaker currency in the market.
That’s why traders closely monitor the release and revision of CPI figures. These data releases can inform their next moves in the market.
Trend Following
Because so many people are following CPI data releases, their collective actions can create market momentum that forms trends. Trend following is a popular trading style that attempts to profit from strong price action in a particular direction over a given period.
When a security is trending upwards (typically characterized by higher swing lows and higher swing highs), trend traders enter a long position. They profit from the continuous upward movement of the market.
In the same vein, when a security is trending downward, trend traders may opt to enter a short position to gain from the continuous downward movement of the market.
A common trading strategy that is based on trend following is momentum trading.
When trading the Consumer Price Index, it’s important to use it alongside other indicators and tools, such as the GDP Price Deflator and the Producer Price Index. This way, traders and investors have a clearer picture of the inflationary pressures moving the markets.
Final Thoughts
The Consumer Price Index (CPI) measures the changes in the costs of a basket of consumer goods and services over a specific time period. It is a widely-used indicator of economic growth and the cost of living in a country. The BLS calculates the CPI using aggregated data regarding the price of everyday consumer items purchased by urban residents.
From a trader/investor perspective, the CPI is a useful tool for measuring inflation rates and how they can impact the markets. Now that the global inflation rates continue to rise, are you utilizing the CPI to help you make better moves in the market?
