What CPI means for investors and traders

When the CPI rises, it usually signals that inflation is imminent. How prices come to rise can happen in a number of ways. Here are the main ones:

• Demand-pull – when demand is higher than supply, prices go up
• Cost-push – when supply falls but demand stays the same, prices go up
• Expectations – when people expect inflation, they act in ways that cause it. For example, if a café chain expects the coffee price to rise, they could raise the price per cup of coffee to pre-empt the expected price increase. By doing that, they raise the price of a cup of coffee even though there hasn’t been any other inflationary factors at play

As investors and traders, it’s important to understand how CPI affects markets. The table below suggests some questions to consider to help get to the answer:

As you can see, there’s no one-size-fits-all answer – each market has its unique context. Let’s look at three historical examples to try to understand how inflation might impact markets.

Stocks in the ‘70s

In the early 1970s, prices for goods and services rose very quickly in the United States due to events like oil shortages and government spending. This made the US dollar weaker, so people could buy less with their money. The cost of living went up.

To try to slow inflation down, the Federal Reserve (Fed) raised interest rates a lot. With higher rates, it was more expensive for companies to borrow money. This hurt their profits and made investors worried, causing the stock market to crash badly – one of its worst declines since the Great Depression long before.

Some people think the stock market goes up when inflation rises. But this shows that when prices rise too fast, eventually it damages markets. What climbs quickly can come down even faster. The 1970s showed that sudden, massive inflation can crush the markets.

Some people think the stock market goes up when inflation rises. But this shows that when prices rise too fast, eventually it damages markets. What climbs quickly can come down even faster. The 1970s showed that sudden, massive inflation can crush the markets.

Gold in the 2000s

In the 2000s, rising inflation helped gold prices a lot. Investors saw gold as a hedge against inflation and dollar weakness. However, gold prices don't rise in isolation. The rise in gold prices in the 2000s didn't just happen because of inflation expectations. Other major factors were also at play. These included:

• After 9/11, the wars in Afghanistan and Iraq drove investors toward gold as a safe haven
• Central banks like those in China and Russia boosted their gold reserves to diversify away from US dollars
• New gold exchange-traded funds (ETFs) made it easier for mainstream investors to buy gold

While inflation concerns did play a role, gold's strong performance in the 2000s resulted from a combination of factors like geopolitics, central bank demand, and financial innovation. The financial markets are complex, with many interrelated forces driving prices up or down. It’s important to keep the global context in mind while keeping an eye on CPI numbers.

Bonds during Japan’s ‘lost decades’

In the 1980s, Japan experienced an economic boom that led to an unsustainable asset bubble. To control speculation and prevent a collapse, the Bank of Japan (BoJ) raised interest rates. Unfortunately, this caused the bubble to burst. Japan's stock and real estate markets crashed, kicking off a long period of stagnation and very low inflation.

With stocks and real estate in decline, investors shifted to Japanese Government Bonds (JGBs) as a safe haven, driving up bond prices. Note that bond prices didn't directly rise because of low inflation. Rather, low inflation was a symptom of broader economic stagnation.

Inflation and bond prices were correlated, but inflation did not directly cause the increase in bond prices. The low CPI figure reflected the weak economic conditions that led investors toward bonds in the first place. This example shows that CPI is intertwined with the overall economy. It is often a symptom, not a key driver, of economic shifts.

How can investors and traders use this information?

CPI can impact markets, but it doesn't drive markets on its own. If you would like to understand how the market behaves around CPI announcements, here are two things to keep an eye on:

• If you think CPI will be higher than the market expected (known as a ‘positive surprise’), keep an eye on the performance of value stocks. These are companies that are considered undervalued or ‘cheap’ compared to their intrinsic value. These types of companies tend to outperform during inflationary periods
• If you think CPI will be lower than the market expected (known as a ‘negative surprise’), keep an eye on the country’s key commodity. Low CPI sometimes suggests lower commodity prices

Remember, one indicator doesn’t provide enough information to make complex financial decisions. In addition to the CPI number, look at price charts, how much risk you can afford to take on, and fundamental indicators.