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 stock markets.
If someone borrows $1,000 dollars from you today and promises to repay it in one year with interest, how much interest should you charge? The answer is the CPI which you can look up on the Bureau of Labor Statistics CPI Index page at http://www.bls.gov/cpi/
The $1,000 you loan out today, you know it will likely to be able to buy the same amount of goods and services a year from now. The CPI website tells us that prices rose 0.7 percent in the U.S. over the last year. To recoup your purchasing power, you would have to charge 0.7 percent interest. You also need to add one or two percentage points to cover default and other risks, but inflation remains the key factor behind the interest rate you charge.
Inflation (along with risk) 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, and commodities.<< Back to Glossary Index