Why CPI Matters

Why CPI Matters

Is the Phillips curve working or not?

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If you watch financial news enough, you will hear about the Phillips curve at least twice a month. Once right around the release of the monthly non-farm payrolls report and once around the release of the report on the Consumer Price Index (CPI). That's not the only time you'll hear it mentioned and debated, but you can rest assured that during those two economic data windows, someone will bring it up. So what is the Phillips curve?

According to our favorite reference site, Investopedia.com; "The Phillips curve is an economic concept developed by A. W. Phillips showing that inflation and unemployment have a stable and inverse relationship. The theory states that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment." In plain English, that means the reverse is also true, that with more jobs and less unemployment, comes more inflation. It's a circle with the energy able to go in either direction. In theory, this would mean inflation was a good thing (because it means more jobs), and mild inflation is, but what happens when you bring in wage growth? Now you not only get more people with jobs trying to buy the same goods, but you get people potentially willing to pay more for those goods to get them. That's when you get the potential problem of hyperinflation which is never a good thing.

 

CPI can confirm or contradict today

In the last non-farm payrolls release average hourly earnings increased 2.9 percent on an annualized basis, the best gain since the early days of the recovery in 2009. This caused rates to spike and caused the "correction" in the stock market that everyone anticipated but seemed surprised when it happened. Markets have since stabilized and come back a bit, but in CPI you get either a confirmation of the Phillips curve of a contradiction to it (for now anyway). If we get a strong CPI number, it can be argued that a strong economy created more jobs which lead to wage increases and a move up in inflation. All the pieces will be there at the same time for the first time. If we see a weak CPI, the non-believers in the Phillips curve will let out another "told you so", rates will head lower and the stock rally will gain steam. 

 

Effect on stocks

Whether we get a strong number or a weak number, a selloff or a rally, CPI will affect stocks directly. Even a number in line with expectations could be seen as bearish given no easing in price pressure. There are clearly other factors, but the CPI conversation in the short-term is the piece of economic data that has the highest probability of moving stocks in a big way. The Phillips curve is not economic fact. The original concept has been somewhat disproven by stagflation such as in the 1970s when both inflation and unemployment were high and rising. It's up to the FOMC however as to whether to cool down the economy if there is inflation or leave it be and wait longer for the Phillips curve to prove itself right....or wrong.

 

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