January 26, 2017 05:30 CST

Consensus Actual Previous
Ex Food-Y/Y -0.3% -0.2% -0.4%
CPI-M/M -0.2% 0.0%
CPI-Y/Y 0.3% 0.5%
Ex Food-M/M 0.0% 0.0%
Ex Food & Energy-M/M -0.1% -0.1%
Ex Food & Energy-Y/Y 0.0% 0.1%

Japan's consumer price index shows that price pressures were again subdued in December, despite a smaller drag from energy prices. Year-on-year increases in the index remain well below the Bank of Japan's target of 2.0 percent.

The headline CPI rose 0.3 percent year-on-year in December, down from an increase of 0.5 percent in November. This is the third consecutive month of positive headline inflation after six months of year-on-year declines in consumer prices. The index fell 0.2 percent month-on-month in December, after no change in November.

The smaller year-in-year increase in headline CPI was mainly driven by slower gains in food prices. Food prices rose 2.5 percent year-on-year in December, down from an increase of 3.6 percent in November. This decline, in turn, reflects weaker growth in fresh food prices. Excluding this category, food price inflation was steady at 0.5 percent.

Core CPI, which excludes fresh food prices, fell 0.2 percent year-on-year in December, up from a fall of 0.4 percent in November. This was the smallest decline in the index since February 2016. In month-on-month terms, core CPI was flat in December as it was in November.

Both headline and core CPI continued to be weighed down by lower energy prices, but to a lesser extent in December. Energy prices fell by 4.4 percent year-on-year in December, after declining by 7.9 percent in October and by 6.7 percent in November. The so-called "core core" CPI index, which excludes the prices of energy and all food items, fell 0.1 percent on the month and was flat on the year in December, after an increase of 0.1 percent year-on-year in November.

This lack of growth in the core-core index reflects offsetting price moves in other important categories of spending. Clothing, health and education costs also rose year-on-year in December, but this was offset by lower furniture prices and housing costs.

Officials at the BoJ argue that both the core and core-core CPI measures understate the strength of underlying inflation pressures in Japan. Their preferred measure of core inflation excludes energy prices and the prices of fresh food, but retains the prices of manufactured and other processed food products which, they argue, are less volatile than fresh food prices. This index rose 0.2 percent year-on-year in November, down from 0.3 percent in October and well below levels seen earlier in the year. The BoJ will publish an estimate for December soon.

Today's inflation data show that the negative impact on Japanese inflation of weak energy prices continued to fade in December. BoJ officials have argued that a weaker drag from energy prices should help to push up both the headline and core CPI over time. However, even excluding the impact of fresh food prices, price increases in other categories of consumer spending remain weak. This is broadly consistent with the assessment of officials that price pressures are likely to remain subdued in the near-term and that their inflation target is not likely to be met until sometime in the fiscal year ending March 2019.

The Consumer Price Index (CPI) is a measure of the average price level of a fixed basket of goods and services purchased by consumers. Annual changes in the CPI represent the rate of inflation.

The CPI has been in the spotlight as Japan struggled to make its way out of deflation. The report tracks changes in the price of a basket of goods and services that a typical Japanese household might purchase. The preferred measure is the year over year percent change. Markets will typically pay more attention to the core measure that excludes only fresh food because volatile food prices can distort overall CPI. A second core measure that excludes energy as well is also available. As the most important inflation indicator, the CPI data are closely monitored by the Bank of Japan. Rising consumer prices may prompt the BoJ to raise interest rates in order to manage inflation and slow economic growth. Higher interest rates make holding the yen more attractive to foreign investors, and this higher level of demand will place upward pressure on the value of the yen.

An investor who understands how inflation influences the markets will benefit over those investors that do not understand the impact. Inflation is an increase in the overall prices of goods and services. The relationship between inflation and interest rates is the key to understanding how indicators such as the CPI influence the markets and your investments.

Inflation (along with various risks) basically explains how interest rates are set on everything from your mortgage and auto loans to government securities. As the rate of inflation changes and as expectations on inflation change, the markets adjust interest rates. The effect ripples across stocks, bonds, commodities and your portfolio, often in a dramatic fashion.

By tracking inflation, whether high or low, rising or falling, investors can anticipate how different types of investments will perform. Over the long run, the bond market will rally (fall) when increases in the CPI are small (large). The equity market rallies with the bond market because low inflation promises low interest rates and is good for profits.