The famed CPI or Consumer Price Index is one of the most important data releases, not only for economists, but also for Fx traders.
If you want to know why, read ahead, but first…
The Consumer Price Index is a measure of overall prices in the economy.
Increase in overall prices = inflation.
Thus, if the Consumer Price Index grows, you have inflation.
So when you hear people talking about CPI, they’re referring to an economy’s measurement of inflation.
This measurement is done by surveying customers each month.
Essentially, the survey collects price information on a variety (or basket) of goods which are deemed representative of the overall pool of goods out there.
For the same reason inflation is important.
If the overall price level in an economy (inflation) grows too fast, individuals may have difficulty affording the same standard of living.
And while this may cause all sorts of trouble, some economists argue the real problem in high inflation comes from other somewhat hidden costs for the economy.
For example, with high inflation, credit becomes considerably more expensive, since nominal interest rates (rate on your loans) depend on inflation expectations.
But at the same time, higher inflation is linked with harder to forecast inflation.
In other words, when inflation is high, both lenders and borrowers have a harder time predicting what inflation next year will be. And the year after that…
Why is this?
Well, think about it this way.
You’re going to lend USD 10,000 to an acquaintance for 1 year.
What rate will you charge? (this is the nominal rate)
You think it’s fair if you get 5%, in other words, a total of USD 500 for your favor. After all, it’s a good acquaintance and you don’t need the money right now.
But you know goods and services will be more expensive next year (inflation).
And for the past few years, inflation has hovered around 2% in your country.
So, if you want to get a real return of 5% on your loan, you should charge this 5% plus what you expect inflation next year to be.
Thus, if you expect inflation to be the same 2% again, you will charge your acquaintance 5% (real interest rate) + 2% (inflation expectation) = 7% (nominal interest rate).
Can you see how inflation affects nominal rates? (these are the rates we see quoted everywhere).
Ok, but so what?
Now imagine some sh&t went down, and inflation ended up being 6%.
What was your real interest (your actual return net of inflation)?
Nominal rate – Actual inflation = 7% - 6%
That’s right, you only made 1% on that deal.
Which means inflation helped your acquaintance and screwed YOU.
If the reverse happens, you end up with a much higher return in real terms, while your acquaintance gets screwed.
See a problem here?
And what about purchasing power?
If like most people, you have a fixed income job…
Well… kiss your budget goodbye.
Say you have USD 20,000 you’ve been saving.
And the economy experiences an episode of hyperinflation (50% in a year).
Suddenly, your USD 20,000 are only worth USD 10,000 in goods….
Your net worth was HALVED!
Crazy, but it’s happened before, in quite a few countries, actually (think Germany, Venezuela, Russia, and others).
This is why Central Banks exist to begin with.
Most Central Bank’s central mandate (see what I did there?) is to maintain price stability in their respective economy.
As such, inflation is one of, if not THE most important variable for Central Banks.
Good, good, but why does an fx trader care?
Thought you would never ask.
In order to maintain price stability Central Banks keep a watchful eye over the Consumer Price Index.
If inflation grows too fast, the Bank will be much more likely to hike interest rates in order to contain price increases.
How does that work?
Higher rates = Less money around.
Less money around = Fewer purchases
Fewer purchases = Producers have no reason to increase prices
And as such, inflation is contained.
Ok, but how does this affect Fx traders?
By now you should know that Central Bank rate changes are the bread and butter of Fx trading.
If a Bank hikes rates, that economy’s currency will appreciate.
Tell me more...
This is because a rate hike necessarily means less money out in the economy (less currency).
By laws of supply and demand, the decrease in currency supply will make such currency gain in price.
And the price of a currency is the exchange rate.
Thus, a change in interest rates conducted by a Central Bank offers Fx traders an opportunity to trade said currency against another (which is hopefully going the opposite direction, or is neutral at worst).
And that, my friends, is why CPI is so important for forex trading.
CPI results are heavily watched by Central Bankers since it’s the best measure of inflation in an economy.
Therefore, keeping an eye on the Consumer Price Index yourself will give you an idea of what a Central Bank might do next, and as such, yield you a trading opportunity.
But please keep in mind, CPI isn’t all telling. A Central Bank might be more focused on other measures at a given point in time.
Some data geeks get all hunged-up on stuff like Consumer Price Index releases because of what we just explained.
However, you can’t be a robot when analyzing Fx fundamentals and sentiment.
There are many, many, many situations in which a Central Bank won’t even care about CPI (barring strong deviations from their expectations).
They may be paying more attention to the labor market.
Or they might be thinking about GDP (economy’s growth).
They may even be thinking about other, more obscure data points.
The point being, you have to be in-tune to what a Central Bank is paying attention to in a given point, and put the CPI under this context BEFORE trading anything.
This point gets further convoluted when you take into account the market’s response to a Central Bank’s communications in mind.
Two different, recent examples:
Federal Reserve says low inflation is “transitory” and won’t affect their hiking plans. The market doesn’t believe them, and the USD goes down with a lackluster CPI.
Bank of Canada says it’s going to hike rates based on many factors other than inflation. CPI data is also lackluster, but the markets actually believed the Bank, and the CAD (Canadian Dollar) soars (or keeps going up) after the release.
Obviously, I can’t possibly encapsulate in a single paragraph everything that was going on in each of those examples.
There’s a saying that markets are irrational.
But I think they are quite justified, if you care to look at psychology, and market sentiment (as simple as reading the news -I’m serious).
And that’s that.
See you soon,
The Forex Economist
Sep 12, 17 09:09 AM
Learn what you need to know about Forex audio squawk here.
Sep 11, 17 09:48 AM
GBP (pound) traders what can you expect from the Bank of England's MPC vote this Thursday, Sep 2017? Click to find out.
Aug 21, 17 04:41 PM
Three of the eight major currencies are commodity currency. But what is that? Which are those currencies, and how can we trade them? Click to find out.