On February 17th the Bureau of Labor Statistics (BLS) released the Consumer Price Index for January. The report for January showed an average 0.2% increase in the cost of goods, which was slightly less than the consensus of 0.3%. The year-on-year index, or the trailing 12 months, shows an increase of 2.9%. When looking more closely at the categories, the report shows that many of the prices rose by between 2% and 3% with the exception of food and energy. These two rose by 4.4% and 6.1% respectively
As can be seen, the indexes for food and energy prices are very volatile, they can swing because of a good crop year, changes in the weather, or a decision by OPEC. Since the prices for such goods often change without regard to demand from consumers, they are left out of some of the CPI calculations. This “core” inflation indicator is what the Fed watches. As we can see in the latest FOMC Minutes, the Fed is seeking a modest 2% inflation for the year 2012 (average inflation since the BLS started collecting data in 1913 is just over 3%). When we look at the change for just the core data (items less food and energy) there was a change of 2.3% for the trailing 12 months ending in January 2012. As long as the Fed can keep things on track, they should have no problem meeting their goal of 2% inflation.
This report, which is released every month, follows the prices of a set basket of goods. The average change of the cost goods is reported in a month-to-month, and a year-to-year change. This economic indicator is the most widely used indicator to determine inflation. By looking at the basket of goods (made up of 40% commodities and 60% services), the BLS can see how the costs of living have changed. The Fed will then use this information to adjust the monetary policy in order to encourage inflation, or encourage deflation.
Besides determining how much buying power the dollar has (if the value of the dollar goes down, inflation goes up) the CPI can give investors and consumers a good picture of what the economy is doing. In the event of rapid inflation there is too much money available, and the costs of good would be rising to meet the demand. In the event of deflation, as seen in 2009, there is not enough money is available, and consumers are not able to keep buying and keep the economy moving. In the event of hyperinflation (a very sharp rise in the price of goods) lending institutions would need to rapidly raise their rates to stay profitable, which would discourage borrowing. In order to maintain order, and to keep the money moving, while keeping the cost of goods growing at a healthy rate, the Fed monitors the CPI and adjusts the money supply and interest rates as needed.