by John Jagerson
CPI in the U.S. was released today with a reading of -.7% for the month. This is the third month in a row of negative CPI numbers. Investors should keep in mind that an extended period of falling prices is defined as deflation and has its own unique risks and opportunities. However, there is a great deal of debate about whether CPI should include food and energy prices as well. Excluding those factors increases "core" inflation for December, November and October to 0%, which is technically not deflation. Because most consumers include food and energy as a significant portion of their budget I would argue that these should be included when analyzing this information.
This is a good debate currently as the difference between negative CPI and positive or flat "core" CPI over the intermediate term is in many ways the difference between a deflationary economy and an inflationary one. Obviously, investment management in these two economic conditions is different and investors should be educated about and prepared for either eventuality. For an inflationary counterpoint to my comments, please see Wade Hansen's analysis of today's CPI numbers here.
In today's video I will walk through what CPI is and why traders think that it will affect yields and therefore currency values. In a normal (non-crisis) market this relationship is very clear and relatively easy to understand. However, there are some big problems inherent in the measure that helps lead to its breakdown when the market is in crisis-mode.
- CPI is subjective: The CPI measure looks at a number of different consumer items and calculates their price changes within a basket with different weightings attached to each item. That sounds simple but it is completely subjective and therefore it is usually very misleading.
- Price shocks are confusing: CPI is usually divided into two components. The first component includes the entire basket of "stuff" which includes food and energy prices. Core CPI, the second component, excludes food and energy from the same basket and for very debatable reasons is often emphasized as more important than the total basket. Clearly the issue with this is that price shocks in the food or energy market will break the normal inflation cycle and the division in the measure makes it very confusing for traders to understand what is going on.
- Comparison is difficult: CPI in the U.S. is not the same as CPI in the Euro-zone or China or any other economy. This makes comparison very difficult which is problematic for forex traders who obviously trade currency pairs.
As you evaluate and analyze CPI keep in mind that the measure is far from perfect, frequently modified and debated. Ultimately the most useful way to use CPI is to watch the trend. If, over a long period, CPI continues to drop traders will have to begin dealing with a deflationary economy. If, however, the Fed/Treasury play is successful and CPI begins to climb again we should plan on an inflationary economy. While we are on the razor's edge the debate will continue to rage.
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