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How Does the Consumer Price Index Affect the Stock Market?

By (Jea Yu )Market OverviewFeb 15, 2023 01:51AM ET
How Does the Consumer Price Index Affect the Stock Market?
By (Jea Yu )   |  Feb 15, 2023 01:51AM ET
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  • The CPI measures the average rate of change in the prices of goods and services consumed by households over some time.
  • It also measures the most significant type of inflation related to your investments.
  • We'll describe the effects of the CPI and why it's essential for your investments and explain how the consumer price index affects stock market action.

The acronym "CPI" may seem familiar if you pay attention to the stock market. It's constantly mentioned in the headlines when referring to inflation.

How is an acronym few people knew or cared about just a few years ago now a top news story and significant stock market mover today? How does the Consumer Price Index (CPI) impact you and your money?

In this article, we'll go over the effects of the CPI and why it's essential for your investments. We'll also explain how the consumer price index affects stock market action.

How Does the Consumer Price Index (CPI) Work?

The CPI measures the average rate of change in the prices of goods and services consumed by households over some time. The CPI meaning coincides with inflation — they are interchangeable.

The U.S. Bureau of Labor Statistics (BLS) releases a monthly CPI report, collecting the prices of over 80,000 items each month through surveys with businesses to estimate overall price changes on baskets of goods and services.

The research report details the price changes in over 200 categories arranged into eight groups: food and beverage, housing, apparel, transportation, medical care, recreation, education, communications, and other goods and services.

CPI Image
CPI Image

What is Inflation?

Inflation takes the same action as prices for goods and services as they inflate and rise. It's the rate at which the general prices for goods and services rise.

When you inflate a balloon, it grows. There are many causes for inflation, such as supply shortages, demand surges, or rising input costs. Inflation causes your purchasing power to erode. As prices go up, you can't afford to buy as much with the money you're making now.

Prolonged periods of inflation may cause wages to rise, and the labor market gets tighter as companies compete for a shrinking talent supply. The CPI measures the most significant type of inflation related to your investments.

How the CPI is Used

Economists, analysts, businesses, and government policymakers use the CPI report differently to help influence their decisions regarding wages, salaries, pricing, and interest rates. Employers use the CPI to measure the cost of living since it considers all the essential products and services typically purchased by households. With this information, they can adjust wages annually to better correlate with the economy. Employers that want to remain competitive for talent, retain employees and sustain the morale of their workforce will be prudent in adjusting worker pay relative to the CPI. The catch-22 is that raising wages can add fuel to the fire with rising CPI. This is especially tough for employers because once they raise wages, it's hard to pull them back down when the CPI falls.

Businesses use the CPI to price their products and services. Rising CPI can lead to the business's erosion of consumer purchasing power and margin compression. Companies have to remain prudent and make pricing adjustments to accommodate a rising CPI. This can often mean raising prices, which may hurt demand but maintain operating margins. Businesses will decide if they're passing the rising costs to the customer or absorbing them internally as margins shrink.

Perhaps most importantly, the U.S. Federal Reserve (the Fed) uses the CPI to determine monetary policy and interest rate changes. If you've wondered how CPI affects stock market reactions, it's to anticipate what the Fed will do with interest rates. When the CPI gets too high, the Fed will incorporate interest rate hikes to cool inflation. Its goal is to bring prices back down without heavily impacting demand. However, rising interest rates tend to cause stock markets to sell off as investors take a risk-off stance and invest in fixed-income instruments. Loan demand also falls with rising interest rates since financing becomes more expensive. Therefore, the Fed must walk a tightrope in determining monetary policy. The CPI has a considerable influence on what the Fed will do.

Effects of Inflation on Stocks

How does the consumer price index affect the stock market? The answer may be surprising if you've ever wondered how CPI affects stocks. It cuts both ways. Inflation refers to rising prices for goods and services and assets like stocks and commodities. Inflation occurs in expanding and growing economies.

These are good conditions for a bull market as demand rises, causing prices to rise. In turn, this results in more spending and more revenues for companies, followed by rising wages. Eventually, wages need to catch up with the inflation rate, or trouble could brew. It can be good for stocks, especially technology companies, as the market focuses on growth over profits, and financing is relatively cheap.

Inflation can also hurt stocks as consumers feel the pinch in their budgets due to the rising prices. Inflation can affect stocks and sectors differently depending on the top and bottom line effects. Consumer staples stocks, including grocery stores, manufacturers of perishable foods, toilet paper, diapers, and personal products, tend to do better during inflation because their margins improve with higher pricing. Consumer discretionary stocks tend to fall as consumers have less discretionary income to spend on apparel, vacations, entertainment, and eating at restaurants.

High inflation can also lead to consumers opting to trade down even from brand names and premium products in both staples and discretionary purchases. Consumers who are used to buying a well-known cereal brand or pasta may trade down to the store brand private label since it's cheaper with matching quality. Consumers who purchase premium drinks may change to non-brand beverages at bars and restaurants. It's a balancing act with consumer staples stocks vs consumer discretionary stocks when balancing a portfolio during inflation.

High inflation ultimately becomes terrible for all stocks, forcing the Fed to adjust monetary policy by tightening the money supply and raising interest rates. Higher interest rates hurt technology and growth stocks due to the higher financing costs, which causes the stock market to sell off as investors take a risk-off approach and move money into fixed-income instruments like government and corporate bonds. All stocks are affected as they generally link to benchmark indexes that sell-off.

How to Defend Your Portfolio Against Inflation

During periods of high inflation, investors tend to take a risk-on approach and invest in growth companies. The stock market tends to rise during rising CPI. However, it ultimately invites the Fed to raise interest rates triggering a sell-off in stocks. Diversification and proper allocation are the keys to defending your portfolio against inflation. While there is no perfect defense against inflation in a portfolio, here are some ways to hedge against inflation.

  • Invest in consumer staples stocks: Invest in consumer staples stocks that benefit from high inflation. These include stocks of companies that provide essential goods and services like food manufacturers, grocery stores, utilities, housing, healthcare, personal care product makers and the stores that sell them.
  • Invest in tangible assets: Invest in tangible assets like real estate and commodities. People still need a roof over their heads, so real estate and housing can be a hedge against rising inflation. Commodities are also a hedge against inflation as prices rise for raw materials.
  • Invest in inflation-indexed bonds: Investing in inflation-indexed bonds like Treasury Inflation-Protected Securities (TIPS) can also help you out. These government-issued bonds offer a fixed rate adjusted for inflation as the principal of the TIPS increases. Make sure to distinguish these from regular Treasury bonds, like the five-year, 10-year and 30-year fixed. These have a fixed yield and may not keep up with the pace of inflation. The Fed raising interest rates to combat high inflation can result in higher yields but falling prices for Treasuries.

Long-Term Tailwinds

Hopefully, you now have a better answer to “How does CPI affect stocks?”

Stock markets ultimately run higher in the long term. Remember this historical fact when adjusting portfolios based on the CPI. The near-term effects of a rising CPI can negatively impact the stock market, but that's why the Fed raises interest rates to combat high inflation. The Fed ultimately targets inflation around the 2% range, which is considered the ideal level of inflation.

As they say, "Don't fight the Fed." It's best to stay the course, has a diversified portfolio of stocks and bonds, and adjusst the allocation as needed.


Here are some of the more frequently asked questions about the CPI.

How does the CPI affect the market?

How does CPI affect the stock market, exactly? Economists look at CPI and other government reports to better determine the state of the economy. Investors look at the CPI reading but also the trend of the CPI. The CPI impacts the markets based on how it anticipates the Fed's reaction. Ultimately, individual companies may react differently to the CPI reading based on how sensitive their business is to consumer sentiment and interest rates.

What happens when CPI increases?

You can interpret "higher CPI" as higher inflation. When the CPI increases, it signals that the cost of living rises and that consumer purchasing power erodes. This can be bullish for consumer staples stocks and bearish for consumer discretionary stocks, as consumers will have less disposable income to spend on luxuries and entertainment.

Is it better if CPI is high or low?

Low CPI implies low inflation, which you can see as a sign of a healthy economy with stable prices and economic growth. Most will prefer a lower CPI, which means lower inflation and keeps buying power strong, as the cost of goods and services remains relatively cheaper. Low CPI is good for technology and consumer discretionary stocks as consumers have the money to make discretionary purchases. Low-interest rates make financing more affordable, allowing for more investment in growth companies.

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How Does the Consumer Price Index Affect the Stock Market?

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How Does the Consumer Price Index Affect the Stock Market?

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