The Consumer Price Index (CPI)

What is important about the CPI?. The CPI or Consumer Price Index is by definition the measurement of the price change in a basket of consumer goods. The CPI can give a good indication as to how the Reserve Bank will view inflation and what it will do in relation to interest rates. The CPI figure can also affect the stock prices, as the market will take a view on a stocks future price with relation to how the CPI may affect an industry sector.

What is it?

The actual goods within the CPI basket are divided into 11 categories: alcohol and tobacco; clothing and footwear; housing; household furnishings, supplies and services; health; transportation; communication; recreation; education. CPI is simply the measurement of change in the overall cost of these items. If the original basket had a value of 100 and this quarter’s costs have risen to 102 we’ll see a CPI rise of 2%. The increase in CPI is called the inflation rate. So in our example, the inflation rate is 2%. Very simple.

Why is CPI important?

Well, it is a very quick way of determining how much more or less people are spending on a day-to-day basis, and from this figure we can determine the kinds of pressures that the economy is under. If the CPI number rises, it may leave the average household or consumer with less money for discretionary spending. Longer term, it means that wages will come under pressure as employees request higher pay, or look for employment opportunities elsewhere.

Employers may also find that the costs of running their business will go up. in an upwards spiral; higher operating costs equals lower profit margins, meaning that companies will have less capacity to meet the higher wage demands employees are now demanding, this means lower share prices. To avoid posting lower profits, businesses must then consider passing these higher costs to their customers, which of course will trickle down to the CPI number itself. Potentially a cycle could occur where higher prices cause higher costs and higher prices again. So we can see why the Reserve Bank of Australia (RBA) keeps such a close eye on the rate of inflation.

The RBA doesn't just look at the whole CPI figure, for their own calculations they take out the 'tradables' (which make up around 40% of the CPI figure) such as food and energy costs, which they class as "volatile". These are excluded as their price alters with currency, climate or seasonal changes.

The real 'meat' of the CPI figure are the 'non-tradeables'; prices set by the institutions such as the banks, property developers and Governments (including government infrastructure businesses such as the power industry). The biggest non-tradeables are probably rents and housing costs.

Some businesses may benefit from a CPI rise. They can use this as justification for putting up prices either by more than the CPI or pass on price rises that have not been affected by CPI, thus increasing their profit margins. For example, a services industry may pass on a 5% price rise, whereas the cost of running their business may have only increased by 1-2%.

It is also important to note that even if the overall number does increase, it may be that several of the 11 categories have actually fallen, but that the rises in the other sectors has been sufficient to cause an overall rise. A rise in alcohol and tobacco and healthcare is not going to have any affect on an individual who is a non-smoking, teetotaller with good health.

What does a higher CPI figure mean to my stocks?

This will vary from stock to stock and probably more importantly, industry to industry. A services industry may have very little exposure to CPI based values, whereas a manufacturer is likely to be more exposed, and therefore their profitability and share price can be influenced by a change in these figures. It is often the unexpected numbers that have the biggest influence on the market. If the market expects a 1% rise and the actual figure turns out to be, say, 3% this is more likely to have an adverse affect. Most economic data has already been factored in before its release, but anything that greatly varies from that expectation is going to have a greater impact. So we can see that it’s not just the figure or percentage but rather the variation away from the expectation that will cause a share price to rise or fall.