The Consumer Price Index (CPI) measures inflation over a given period of time. Essentially, it serves as an economic indicator that gauges the effectiveness of economic policy.
The CPI shows how much the price of certain goods and services increases, typically signaling our nation’s central bank, the Federal Reserve, to adjust its monetary policy. These interest-rate adjustments can either stimulate the economy or aim to control inflation.
What Is the CPI?
The CPI is an economic measure produced by the U.S. Bureau of Labor Statistics (BLS). It tracks changes in the price level of a basket of consumer goods and services typically purchased by U.S. households.
“The Consumer Price Index, or CPI, is basically a way to measure how prices are changing for the things we all buy regularly, like groceries, gas, rent, and healthcare. It’s like a pulse check on the cost of living. It’s important because it helps us understand inflation — whether our money is going further or if prices are squeezing us,” says Gabe Krajicek, CEO of Kasasa, a fintech company that works with small banks and credit unions.
This index allows economists to understand inflation by examining how prices change over time. For everyday Americans, the CPI is important because it affects purchasing power. When the CPI increases, the cost of living also increases.
If your wages don’t keep up with inflation, the value of your income is decreasing. With the passage of time, inflation could lead to economic hardship since you can’t buy as much with your money as before. As a preventive measure, it’s important to protect your assets and wealth against inflation.
[Inflation Calculator: See How Much Inflation Is Costing You]
What Is Inflation?
Inflation is when the prices for goods and services rise, eventually eroding purchasing power. In other words, your dollars buy fewer goods and services over time.
Several things can cause inflation, like increased production costs, higher product demand or expansionary monetary policies (adding more money to the nation’s money supply). Some industries, such as food and beverage, transportation and energy sectors, are more sensitive to inflationary pressures.
Consumer goods that rely heavily on raw materials or have significant transportation costs may experience more drastic price fluctuations. For instance, increased fuel prices can directly impact the cost of goods that require shipping, affecting the supply chain and, eventually, the prices of consumer goods.
[Tips to Make Ends Meet During High Inflation]
How do Interest Rates Affect Inflation and the CPI?
Typically, when the Fed reduces the Federal funds rate, it encourages more borrowing and spending, boosting demand for goods and services.
“Lower rates are designed to stimulate the economy, but if demand outpaces supply, prices rise, thereby impacting the CPI,” Krajicek says.
If the relationship between the prevailing interest rates, the CPI and inflation still seems somewhat abstract, Thomas Savidge, research fellow at the American Institute for Economic Research, provides a useful illustration: “It’s best to think of the inflation rate and the general level of prices like a tachometer and speedometer in a car. The tachometer measures how rapidly the car is speeding up (like the inflation rate measures how rapidly prices are rising). In contrast, the speedometer measures how fast the car is going (like the general level of prices measures how much things costs).”
“You can put the car on cruise control so the tachometer remains low, but the car can still be going 80 mph. In the same respect, inflation can be low, but prices can still be high,” he adds.
Disinflation Explained
The September 11, 2024, update of the CPI summary by the BLS states that, “The all items index rose 2.5 percent for the 12 months ending August, the smallest 12-month increase since February 2021.”
When inflation is slowing down, as the latest CPI report suggests, the phenomenon is known as disinflation.
In a speech in August, Jerome Powell, the chair of the Federal Reserve Board said, “Our objective has been to restore price stability while maintaining a strong labor market, avoiding the sharp increases in unemployment that characterized earlier disinflationary episodes when inflation expectations were less well anchored. While the task is not complete, we have made a good deal of progress toward that outcome.”
This commentary indicates that Americans can expect more interest rate cuts with the prospect of more disinflation in the near future.
How Will Lower Interest Rates Affect My Purchasing Power?
Lower interest rates make borrowing more affordable and can urge consumers to make bigger purchases.
“You might see more activity on big-ticket items and categories such as home purchases and auto sales. Categories like home furnishings, consumer electronics and travel might also see a rise, as consumers feel more confident in spending,” Krajicek says.
On the flip side, he notes, “Housing and rental prices may increase due to greater demand for mortgages. On the other hand, savings-related products, which earn less interest, might become less attractive, shifting spending patterns toward consumption rather than savings.”
[READ: How to Save Money: 10 Expert-Backed Ways]
What Else Should You Watch When Interest Rates Drop?
When interest rates drop, it could be a good time to analyze your long-term financial strategy.
You could explore refinancing existing loans to take advantage of lower rates, which can reduce your monthly payments and save money over time.
You may also choose to invest more heavily in equities or real estate, which can appreciate considerably, as lower rates often stimulate these markets.
Finally, revisit your savings strategy, as lower rates can decrease returns on savings accounts, which means you may seek other ways to preserve and grow your wealth.
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What Is the CPI? What to Know Now That Interest Rates are Falling originally appeared on usnews.com
Update 10/09/24: This story was published at an earlier date and has been updated with new information.
