US CPI Primer: Understanding inflation and its impact on portfolios

The other common inflation measure is the personal consumption expenditure index (PCE) which is constructed by the Bureau of Economic Analysis (BEA) and is released toward the end of each month. Historically the two measures of inflation have seldom deviated significantly, but that has changed recently.

Essentially, CPI measures the change in direct expenditures for all urban households for a defined basket of goods and services. All expenditure items are placed into over 200 categories, arranged into eight major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. The three largest components of CPI are housing, transportation, and food/beverages.

However, policy makers prefer to focus on the (core) PCE index as it reportedly captures the latest consumption trends more effectively given that the CPI uses an index formula which only updates item weights biannually (moved to annual updates from 2023) but the PCE index updates item weights every quarter. So PCE effectively captures substitution effects, whereby consumers switch products due to relative price differences, and this is why usually CPI is higher than PCE because it does not capture the switch to cheaper products which might be occurring.

Another reason of preference for PCE is that it considers expenditures made by urban and rural consumers as well as expenditures made on their behalf by third parties, as against CPI that uses a narrower definition of consumer expenditures and only considers urban expenditures made directly by consumers.

While CPI and PCE measure inflation from the consumer standpoint, there is another measure, the Producer Price Index or PPI, which is also reported by the BLS and measures inflation from the perspective of producers. PPI measures the average change over time in the selling prices received by domestic producers for their output.

Measures of inflation – headline vs. underlying vs. core

The other common terminology we come across is the headline inflation, which reflects the overall change in the level of prices, vs. the core inflation, which excludes price changes in certain goods which are known to have volatile or seasonal price fluctuations, such as food and energy prices.

Meanwhile, underlying inflation is measured via median or trimmed mean metrics in which components of inflation that show the lowest or highest price changes in the basket are removed to get rid of the noise or transitory factors. For instance, a hurricane causes a large change in say the price of apples or a medical rebate for a year brings healthcare costs down temporarily, then these effects have to be removed to understand the true “underlying” price pressures in the economy.

What makes inflation so important for markets?

It is easy to understand that inflation affects consumer spending as it reduces your purchasing power. But implications are also inevitable for your portfolios as inflation can also reduce the value of investment returns. In addition, inflation prompts central bank action as they usually have mandates to bring inflation to a target level in the long-run. So, central banks attempt to control inflation by regulating the pace of economic activity, which is regulated by raising or lowering short-term interest rates. This has a varied impact on various asset classes.

The Federal Reserve has a dual mandate – to sustain maximum employment and price stability. In 2012, the FOMC published its “Statement on Longer-Run Goals and Monetary Policy Strategy”, which communicated a long-term target inflation rate of 2%. However, a flexible average inflation targeting regime was adopted in August 2020 which allows inflation to exceed 2% for some time until the average returns to 2%.

How to trade CPI releases?

Most commonly used instruments to express a view on US inflation are:

• US dollar and other USD FX pairs such as USDJPY or EURUSD
• Treasury Bonds
• USD-traded commodities
• Indices like NASDAQ (USNAS100.I) or S&P 500 (US500.I)

CPI reports are generally followed closely by traders and investors as these influence central bank decision on raising or cutting the interest rates, which strongly impact the market sentiment towards various asset classes. The actual inflation print is compared not just to central bank’s target, but also to the street forecast.

Typically, an inflation that is higher than central bank’s target or street expectations will prompt tighter monetary policy action, resulting in a negative impact on stocks (on expectations of weakening economic activity) and nominal fixed income (on expectations of higher yields) as well as a stronger currency. Conversely, inflation prints that are below expectations or target could prompt loosening of monetary policies that result in gains in equities and bonds, while the currency could come under pressure. Both momentum trading and fade the data trades, as discussed in the nonfarm payroll primer, are interesting on such key data/event days. Option trading is also quite popular around CPI release days as volatility picks up.

For investors, it is important to consider the impact of inflation on portfolio returns, and maintaining a constant allocation to inflation-hedging assets in order to cushion portfolios against unexpected spikes. Popular inflation-hedging instruments include inflation-protected bonds such as Treasury Inflation-Protected Securities (TIPS) or floaters, commodities or real estate. Gold also tends to fare well when real interest rates are low or negative, that is when inflation is high but interest rates are still low.