The consumer price index (CPI) is an average measure of the level of the prices of goods and services bought for the purpose of consumption by the vast majority of households in the UK. It is calculated using the same methodology developed by Eurostat, the European Union's statistical agency, for its harmonised index of consumer prices (HICP). The CPI is the Bank of England's target inflation measure.
The consumer price index is the most widely followed indicator of inflation. An investor who understands how inflation influences the markets will benefit over those investors that do not understand the impact. In countries such as the UK, where monetary policy decisions rest on the central bank's inflation target, the rate of inflation directly affects all interest rates charged to business and the consumer.
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 Treasury bills, notes and bonds. 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.
For monetary policy, the Bank of England generally follows the annual change in the consumer price index which is calculated using the European Union's Eurostat methodology so that inflation can be compared across EU member states.