What Is the Consumer Price Index?

The consumer price index, or CPI, is a measure of how prices change over time.

It’s calculated by taking an average of the change in price of a basket of goods that represent the regular expenses for consumers from year to year. These goods include food, utilities, gasoline, health care and the cost of housing.

A rise in prices translates into a higher CPI, which the Bureau of Labor Statistics (BLS) reports as a percentage increase.

“By tracking a broad basket of prices over time, we can make judgments about aggregate price levels,” says Robert Dye, chief economist at Comerica Bank. “We typically call the changes in aggregate price levels the rate of inflation.” Here’s what you should know about the CPI…

— Measuring inflation and deflation.

— CPI-U versus CPI-W: which to use.

— Why the CPI matters to investors.

[Read: How Inflation and Deflation Impact Your Investments.]

Measuring Inflation and Deflation

A positive CPI signals periods of inflation, while a negative CPI indicates periods of deflation.

“Essentially, inflation measures changes in price levels across the economy and thus can also be considered a measure of consumer purchasing power,” says Michael Sheldon, executive director and chief investment officer of RDM Financial Group. When inflation rises, consumers have to pay more for goods and services — meaning they get less for their money.

This may make inflation sound like a bad thing. After all, wouldn’t you rather get 10 gumballs for a quarter instead of just one? Of course you would. That said, some inflation is actually good for you and the economy.

“Modest inflation of around 2% is a sign of a healthy economy as it is usually driven by sustained economic growth of goods and services, which creates jobs and rising wages,” says James Ragan, director of wealth management research at D.A. Davidson. “This in turn supports increased consumer spending and more growth.”

In a robust economy, wages grow faster than the price of goods, so even though you need more dollars to buy your gumballs, you have those extra dollars available.

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CPI-U vs. CPI-W: Which to Use

The BLS publishes two CPI figures: The CPI-U — or consumer price index for all urban consumers — is designed to reflect the spending habits of almost all urban and metropolitan residents, including working professionals and those who are self-employed or unemployed and retirees. The CPI-U does not include people living in rural areas, farm households, the military or institutionalized individuals.

The CPI-W — or consumer price index for urban wage earners and clerical workers — looks at a subset of the CPI-U: only households in the CPI-U that get more than half their income from clerical or wage occupations and have at least one earner who was employed for at least 37 weeks during the previous 12 months.

For most uses, investors should pay attention to the CPI-U as this is “the more commonly followed number as it represents all urban consumers, covering a much larger segment of the population than CPI-W,” Ragan says. The CPI-W represents only about 29% of the total U.S. population, while the CPI-U represents about 93%, according to the BLS.

“A subset of the CPI-U is ‘core’ CPI, which reports the CPI-U price changes less the impact of food and energy,” Ragan says. “This number is important because food and energy prices are often volatile, which can skew the monthly numbers.”

A core CPI that is less than overall CPI-U suggests underlying inflation is most likely lower than the reported number, he says. “Conversely, if the core inflation increase is higher than the headline CPI-U, it suggests that inflation across the country is vulnerable to moving higher.”

With this measure of inflation, consumers can answer an important question, Dye says: Is the price of something going up because of changes in supply and/or demand, or is the price of something going up because prices are rising generally in the economy and all the inputs to that good or service are rising in price?

The answer to this question can have important implications for investors.

[READ: Investing In Stocks for Beginners.]

Why the CPI Matters to Investors

“The rate of inflation has important implications for financial markets,” Dye says. It’s a key factor in valuing both stocks and bonds.

Inflation is a negative for bond owners because their coupon payments are usually fixed. As inflation rises, that fixed $100 coupon can’t buy you as much as it could when you purchased your bonds. Thus, higher inflation rates erode the value of your future stream of coupon payments and principal repayment.

If the inflation rate is greater than the bond’s nominal interest rate, which is the stated coupon rate, your real interest rate after inflation would be negative. In such cases, “the investor is actually worse off,” Ragan says. “In today’s world of historically low interest rates, and inflation around 1.5%, the real return of interest bearing securities is very low.”

Equity markets, on the other hand, typically perform well in a growing economy with modest inflation, he says. While “a sudden, unexpected increase of rapid inflation can create headwinds for companies as costs move higher,” overtime, those “companies will be able to raise prices, contributing to higher revenues and profits, which are positive for equity investors.”

Where things go wrong for stock investors is if inflation rises to more than 3% for a sustained period of time, he says. This could signal an “overheating economy, which could lead to investor concern and weaker stock prices.” In such periods, commodities are expected to outperform.

“Real estate is another area that could potentially benefit from rising inflation as landlords may have the ability to raise rents to offset a rise in inflation,” Sheldon says. “However, every period is different, and there are several different categories within real estate, so investors need to really do their homework.”

Since 1977, the Federal Reserve has operated under the dual mandate of maximizing employment while keeping prices stable — in other words, while controlling inflation. After the global financial crisis, the Fed adopted a 2% inflation target, but this year it changed that to an average target of 2%.

“This likely means that the Fed is willing to let inflation trend above 2% for longer periods of time, which could be positive for jobs growth, wages and economic activity,” Ragan says. This is likely good news for equity markets.

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What Is the Consumer Price Index? originally appeared on usnews.com

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