How the Latest CPI Could Save the Dow


The Dow Jones Industrials continued their recent advance this morning, gaining 110 points as of 11:30 a.m. EDT. Economists pointed to relatively minimal increases in inflation from this morning's Consumer Price Index report as one reason for the rally. Let's take a closer look at the CPI report and the impact it could have on the Dow not just today but well into the future.

Is inflation dead?
The CPI measures changes in prices that consumers pay for goods and services. By looking at a representative basket of goods and services that reflects typical consumer expenditures on housing, transportation, food, and other major categories, the Bureau of Labor Statistics gathers data that it then analyzes to assess the impact that price changes have on the typical consumer.

This month's headline CPI figure indicated little change in overall prices, with a 0.1% increase in May and a 1.4% rise over the past year. Some economists also point to the so-called core CPI, which excludes the impact of food and energy costs. Although taking those costs out might seem like a major omission, the resulting figures aren't as volatile and therefore serve as a more useful guide for some purposes, and a rise in May of 0.2% for core CPI was equally tame.

Drilling down on what's costing more
When you look more closely at the CPI figures, you'll find some interesting undercurrents in the domestic economy. Most investors see the recovery in housing prices as a good thing, given direct influence on homebuilder stocks and indirect effects on many other companies. For instance, Dow component Home Depot owes much of its recent success to better conditions in housing, as its focus on both consumers and contractors has helped it take maximum advantage of the favorable trends in the industry.

But rising housing prices also show up indirectly as a major component of the CPI, with a weighting of more than 31% of the entire index. In May, the rise of 0.3% in the shelter index accounted for more than half of the overall increase in the CPI. The way housing gets included in the CPI is somewhat controversial, as its use of a concept called owners' equivalent rent doesn't always track with true home prices, but recently, both rents and purchase prices have shown strength in many markets across the nation.

In addition to housing, natural gas and electricity costs posted substantial gains, while air travel and recreational expenses climbed along with clothing costs. The strength in airfares is consistent with what we've seen from Dow Transportation Average components United Continental and Delta Air Lines , as both companies have benefited from industry consolidation that allows them to stand firm on fares and implement fee-income initiatives that have helped them dramatically improve their bottom lines.

Not all prices rose, however. Medical care and food prices declined along with the costs of used vehicles, offsetting some of the rises elsewhere.

What the CPI means right now
Perhaps the most important application of the CPI right now comes from the Federal Reserve's use of the figures in assessing how much room it has to sustain its accommodative monetary policy. When inflation picks up, many Fed officials get concerned and look to tighten policy to keep prices in check. Yet after unprecedented levels of Fed intervention in credit markets, investors are uncertain about what effect the Fed's withdrawal will have. For now, the CPI is pointing to a lack of inflationary pressure, giving the Fed some more time before it needs to start making more definitive decisions about the end of quantitative easing. At least recently, that has generally been good news for the stock market.

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