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CPI and inflation

The Consumer Price Index (CPI) is a measurement of price movements for goods and services from the consumers’ perspective. It determines the buying power of the dollar and is considered a key tool for determining inflation.

The month-over-month change rate in CPI is called the MoM inflation rate and the year-over-year change rate CPI is often referred to as the (YoY) inflation rate, which are both included in the monthly CPI report published by the Labor Statistics.

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The 2021-2022 inflation surge

A moderate inflation level can be considered a sign of a healthy economy because a growing economy generates growing demands for goods and services. In contrast, an inflation level that is too low or too high can cause a destructive cycle.

The most obvious impact of persistently high inflation is that real purchasing power will decrease if consumer earnings have not risen in tandem with inflation. The loss of real purchasing power can slow down consumer spending, increasing the likelihood of recession.

The U.S. economy has experienced surging inflation since mid-2021. Although the cause of this inflation surge has been the subject of heated debate, many factors are thought to contribute to it, which include the Covid-19 pandemic, an increase in domestic money supply, and the war between Russia and Ukraine.

Source: tradingeconomics.com

Inflation and interest rate

Like other central banks, the Federal Reserve attempts to maintain inflation at moderate, targeted levels, by influencing interest rates. When inflation is too high, the Federal Reserve will typically raise interest rates to lower inflation, accepting that this will most likely slow down the economy and increase unemployment. When inflation is too low, the Federal Reserve will typically lower interest rates to stimulate the economy, accepting that this will necessarily bring inflation up to some degree. It's important to remember that today's inflation rate release is only one data point. Investors usually pay close attention to how the Fed will digest more information before its next announcement.

When the Fed is trying to balance the economy, taming inflation by raising interest rates is the overarching goal. However, this requires caution. Aggressive or “hawkish” tightening policies risk triggering a recession and potentially destabilizing the entire financial system.

As shown in the below chart, the inflation rate has accelerated since early 2021. The Fed responded by approving their first interest rate increase of 25 basis points in March 2022, with more aggressive hikes in the following meetings. Raising rates at a pace the market can absorb and managing expectations are very important for a successful plan.

Source: tradingeconomics.com

How does the stock market respond?

In most cases, major indices will fall on the announcement of a rate hike, because rising interest rates raise borrowing costs for companies and consumers and weigh on economic activity. Growth stocks are particularly sensitive to rising interest rates due to the negative outlook higher interest rates create for future cash flows, tamping down projections and stunting investment in growth prospects.

How do investors trade the CPI report?

Long-term investors can predict where the stock market is heading in a month or a year according to the CPI report.

For short-term investors, CPI report releases offer more direct trading opportunities.

Investors can compare the actual release with the previous release. If the inflation rate is lower or has slowed its increase speed, it’s possible that the rate hike could pause. The stock market is then likely to surge. Otherwise, the rate hike may continue, causing the stock market to plummet.

Investors can also compare the actual release with the forecast. If the inflation rate is lower than expected, the market could also climb higher.

For example, on November 10th, 2022, the October CPI report was released with a lower-than-expected inflation rate. The S&P 500 index surged more than 5%, as the market believed that the Fed would slow its rate hike pace. The Nasdaq-100 composite surged more than 7%. On the same day, ETFs tracking SPY and QQQ rose by 5.5% and 7.38%, correspondingly.

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The bottom line

The monthly CPI report reveals the inflation rate and offers grounds for interest rate adjustment. Investors can trade the CPI report release by making a judgment on the stock market according to the inflation rate.