What is CPI and its importance in Forex Trading
Did you know you need more than price charts to be a successful and consistent trader?
The reason why so many traders fail is they focus too much on price charts. They don’t pay any attention to the real reasons why prices are moving.
Supply and demand is the driving force of Financial Assets. Not price charts!
The is why Fundamental analysis is so critical. It allows traders to understand the supply and demand of different currencies.
The most essential tool in Fundamental Analysis is Economic Indicators.
In this article, we will discuss one of the most important economic indicators. It is called the Consumer Price Index.
Or CPI for short.
Understanding economic indicators
Let us start by understanding economic indicators a bit better.
The most essential tool in Fundamental Analysis is Economic Indicators. Economic Indicators are statistics about economic activity.
These indicators can reveal the overall health of an economy.
Slowing economic activity leads to a weaker economy. Expectations of a slowing economy cause less demand for its currency.
Rising economic activity leads to a stronger economy. Expectations of a growing economy cause more demand for its currency.
The impact of economic indicators
Why do specific economic indicators have more impact than others?
The answer is because of monetary policy. Monetary policy is performed by central banks to manage a country’s money supply.
The most popular tool used to control the money supply is by adjusting interest rates. Interest rates are an essential factor in determining the value of a currency.
When interest rates rise, currency values usually increase. When interest rates fall, currency values typically depreciate.
The impact of economic indicators depends on how they will affect interest rates.
Central banks use economic data to help them evaluate when to raise and cut interest rates.
Inflation is one of the most important data points used by central banks.
What is Inflation
Inflation can be described as the rise in prices for goods and services. Have you noticed how things get more expensive every year?
When the prices for goods and services go up, we call that inflation. When prices for goods and services fall, we call it disinflation.
Inflation occurs when the average prices for things go up over time.
What does it mean when someone says inflation is 3% this year. It basically means average prices of things are 3% more expensive this year compared to last year.
Inflation causes the value of money to decrease. Every time prices go up it reduces the number of things we can buy with our money.
What is CPI
CPI is short for Consumer Price Index. It is one of the most widely used measures of inflation.
The CPI measures the change in prices for a specific basket of goods from one period to another.
CPI year over year measures the change in prices for the specific basket of goods from one year to another.
CPI month over month tracks the change of prices for the same basket of goods from one month to another.
What type of things are measured as part of this basket?
- Energy (the cost of fuel and gas)
- Housing (the cost of property and renting)
- Transportation (the cost of public transport, logistics etc.)
- Healthcare (the cost of medical treatment and medicine)
- Food (the cost of different types of food, normally staples)
- Education (the cost of various types of education)
- Clothing (the cost of various types of clothing)
Two kinds of CPI
There are two different types of CPI readings that are important to differentiate.
These two are known as Headline CPI and Core CPI.
Headline CPI is the standard measure of inflation for the same basket of goods. This measure can be very volatile from one period to another.
Prices from one year to another can jump or fall substantially.
Food prices might be inflated in a prior year due to things like bad weather. Energy prices might be inflated in a previous year due to a war in the middle east.
These are just a few simple examples, but you get the point.
For a more accurate measure of real inflation, we look at Core CPI. Core CPI is inflation excluding food and energy prices.
Central banks normally focus on Core CPI as it strips out possible noise.
Is inflation good or bad
This will depend on where an economy is in their business cycle.
Every economy will go through various cycles. The most well-known business cycles are recessions and expansions.
Inflation can be good or bad depending on the current health of an economy.
An economy that is at the peak of an expansion phase is expected to have higher inflation. Economies that are in a recession cycle are expected to have lower inflation.
For the most part, central banks prefer to keep inflation in a sweet spot. That is why they have inflation targets.
These targets are considered as the optimal inflation level. It is the inflation level which promotes sustainable and stable growth and employment.
There are also some severe cases where inflation gets completely out of hand in an economy.
Too high inflation is when prices are hyper-inflated and is called hyperinflation. Too low inflation is also a problem and is called deflation.
Both hyperinflation and deflation can be devastating to an economy. Central banks will also try everything they can to keep their inflation in check.
CPI and Interest Rates go hand in hand
It comes back to central banks. We know central banks are responsible for adjusting interest rates.
Interest rates have a tremendous impact on currency values. Inflation is the most influential indicator used by central banks.
They use it to evaluate economic health and decide future monetary policy.
Most central banks have specific targets where they want inflation to be. This is often referred to as inflation targeting.
The inflation target differs from country to country. For developed economies, a target of 2% is considered the sweet spot for inflation.
Central banks have mandates to keep inflation as stable as possible. Usually, they adjust interest rates to keep inflation as close to these targets as possible.
How lowering interest rates will affect inflation?
When interest rates are low the cost to borrow money is low. This means companies and consumers are motivated to borrow money more freely.
Lower interest rates cause companies to borrow money to expand and grow. As they expand and grow, they will require more workers.
This causes employment to rise and means more people have work and has money to spend. As people earn more money they start to spend more.
The increase in spending causes more demand for goods and services. When the demand for goods and services grow faster than the supply the prices go up.
This is a very basic example of how lower interest rates can indirectly increase inflation.
When inflation is too low, central banks will lower interest rates to boost inflation. If inflation is too high, the central bank will raise interest rates to lower inflation.
How raising interest rates will affect inflation?
When interest rates are high borrowing costs are also high. This means companies and consumers are discouraged from borrowing money.
Higher interest rates mean companies don’t want to borrow money to expand and grow. As companies stop borrowing money the economy starts to contract.
Slowing economic activity means companies start losing money due to slower demand. As demand slows companies start losing money due to high production and fewer sales.
This causes companies to cut back on staff. Unemployment starts to increase which means fewer people have money to spend.
The decrease in spending causes less demand for goods and services. When the demand for goods and services falls below the supply the prices will drop.
This is a very basic example of how higher interest rates indirectly lower inflation.
Why CPI data is important in Forex Trading
Market Expectations directly impact the supply and demand of currencies.
Demand for a currency will rise if markets expect a central bank will raise interest rates. Similarly, demand will fall in they expect a central bank to cut rates.
Inflation data can help traders anticipate how central banks will adjust rates.
This is where the inflation target for each central bank is important. When inflation moves too far from their target the market will anticipate rate adjustments.
The moment expectations for rates change it can provide great trading opportunities.
How to use CPI data in Forex Trading
The first step is to find out what the inflation target is for various central banks. This is info you can find easily with a quick google search.
Find out in what type of rate cycle a central bank is in currently. Are they hiking, cutting or holding rates steady.
The biggest impact comes when inflation data causes markets to change their expectations.
An example is when markets expect higher rates, but inflation data start to point to a need for lower rates.
The third step is finding a reliable economic calendar. Find out when CPI releases are due and tune into the markets when they occur.
Watch how the markets react to the release and do research on why markets reacted the way it did. Find out what market analysts say about the event before and after it happens.
In this article, we learnt what inflation is and why it’s important for economies.
We also saw why CPI has such a large impact in Forex Markets and how we can use CPI releases to our advantage.
The best way to learn how to use economic data in your trading is through practice. There are no shortcuts when it comes to trading.
Make sure to leave any comments or questions below.