What is a Consumer Price Index and How Can You Trade It

The Consumer Price Index is one of the major items on any Forex Economic calendar. According to the CPI definition, It tracks the change in the price level of the basket of goods and services in a certain period of time. The exact composition of items and methodology of calculations vary from country to country. However, CPI is still considered as one of the most important measures of inflation.
 
For a regular trader, following CPI numbers is important for various reasons.
 
Firstly, it is worth noting that most of the world’s major central banks target inflation. Therefore, the latest changes in CPI can give some clues, regarding the future path of the interest rates and monetary policy in general. For example, if in the given country the inflation rises well above the desired target, then the local Central Bank may respond with hiking interest rates and this can strengthen the currency.
 
In addition, CPI effect on Forex usually takes more time to manifest. According to the Purchasing Power Parity, in the long term, currencies with low inflation tend to appreciate the ones with a higher rate of price level increases. This can be one way to explain the decline in the USD/CHF and USD/JPY in recent decades.

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Consumer Price Index Explained

According to the official website of the US Bureau of Labor and Statistics, the Consumer Price Index measures the average change over time in the prices of urban consumers for the basket of goods and services. This consists of several spending categories, to find out more details, let us take a look at this Consumer Price Index table:
Consumer price index explained
As we can see from this chart above, in the consumer price index formula includes:
  • Housing expenses, which represent the largest component of CPI, composing more than 40% of the Index.
  • Food and Beverages category composes 15% of the index.
  • The transportation sector is represented by approximately 15% share in CPI.
  • Medical Care
  • Recreation
  • Education
  • Apparel
  • Other Goods and Services

How is the CPI Calculated

As a trader, understanding the meaning of CPI in Forex is equally important whether you are a technical trader or a fundamental one. Technical traders base their decisions on past market price action, however, they can still use economic events for determining general direction. And many traders do use fundamentals to get a clue about where the prices are heading and apply technical tools and strategies to trade in the general direction.

Each component has a list of sub-categories, for example, the Food and Beverages section has Bakery Products, Meats, Eggs, Dairy Products, Fruits and Vegetables, Sugar and Sweets, Snacks, Baby foods, and other items.
 
The composition of the CPI is not fixed, every single year the weights of each category are reviewed and adjusted to account for changes in consumer behavior.  It is updated every month, and the consumer price index calculator is also available on the BLS website.
 
Depending upon the economic conditions, the rate of CPI can fluctuate significantly; however, according to the official data, the average long term inflation in the US stands around 3%.

This measure is one of the most critical economic indicators. In fact, like many other Central banks, the Federal Reserve targets 2% inflation in the medium term.

The higher inflation can lead to the rapid depreciation of the purchasing power of the currency and also wipe out the real value of savings. Even 2% annual inflation assumes that prices will still double every 36 years; at 4% this process can take only 18 years. Therefore, if the Federal Reserve started tolerating such high levels of price increases, that can certainly undermine economic stability and the reserve currency status of the US dollar.
 
So then, why not target 0 or 1% CPI? The official explanation by Central Bank officials is that this can increase the chances of deflation in the economy. The problem being that it is difficult to enforce the negative interest rate policy. So what do they mean by this?
 
Well, for example, if the inflation rises to 3%, then the Central Bank can raise rates, perhaps even exceeding that rate and curb those price pressures. However, if the CPI falls to -1%, then the Federal Reserve can not do the same thing and enforce negative rates.
 
If, for example, one day the Federal Funds rate dropped to -1 or -2%, then instead of paying interest to banks, the depositors will pull out their money and keep their savings in cash, avoiding those potential losses. So from their perspective, it is easier to address inflationary pressures, than to fight deflation.
 
Actually, there is another reason for the 2% inflation targeting policy, which is very often overlooked. In the majority of developed countries, both governments and households have a very large amount of debt. If the Central Banks tolerated deflation, then the liabilities of those entities would gain purchasing power and make the burden of repayments incredibly more difficult.
 
On the other hand, with 2% inflation, the real buying power of those debts will slowly, but steadily fall, which can benefit indebted governments and households.

How does the Consumer Price Index affect Forex?

Considering the fact that the Central Bankers across the globe are actively aiming at the rate of change in the price levels, the CPI can play a key role in their decision-making process. They may not respond to the small deviations from their targets. At the same time, if the differentials are considerable and persistent, then they might decide to change the interest rates in order to respond to those challenges.
 
This tendency is well illustrated by the actions of the European Central Bank from 2011 to 2016. After the Great Recession of 2008, the ECB held the key interest rate at 1%. By 2011, with increasing oil prices, the Eurozone inflation had risen considerably, at one point reaching 3%. Since this was well above the target, the governing council of the bank decided on two rate hikes, bringing it to 1.5%.
 
By the end of this year, the price pressures began to subside. At the same time, it became apparent that the Eurozone Debt Crisis was not going away anytime soon and could potentially weaken the economy even further.
In response, the ECB cut rates repeatedly, until reducing it to zero by 2015. At the time, the HICP had already turned negative, leading to a brief deflationary period in the Eurozone. However, the above-mentioned policy change eventually paid off, with inflation returning close to the intended target.

Russia's war in Ukraine and increased demand for oil and gas as well as wheat and other basic products has caused a massive inflation around the globe. In November 2022, the central bank of the USA increased rates by 75 basis points to 3.75% – 4.00%. The EU, UK and other countries have also increased their interest rate numbers. The main idea behind interest rate rise is limiting money supply, which will lead to a stronger currency.

How CPI affects forex short term

CPI numbers are the main reason Central Banks make interest rate decisions. However, guessing the direction of exchange rates is not always so simple. When making decisions on Monetary Policy, Central Bankers do consider other economic indicators as well. This is something to keep in mind when considering the effect of CPI on Forex.

In case you are wondering how to trade CPI news, it might not be as simple as it sounds. As already mentioned, high inflation is a trigger, but it doesn't always lead to increased rates. What's more, market reactions to CPI announcements are often unpredictable. In general, when trading news, predicting price moves short term is highly challenging. The reason is that many long term investors hedge their risks during news announcements. Meaning, place orders against their existing long term orders to protect them from ill effects of announcements. Which makes trading the news unpredictable. Most news trading strategies are not trying to guess price direction. Most of the traders are using Buy Stop and Sell Stop order types, so that when price starts jumping towards either direction, they'll be able to catch the move.

Long term Effects of CPI

Developments in the Consumer Price Index also can have a long term impact on the exchange rates. The Purchasing Power Parity theory states that currencies with lower inflation rates tend to appreciate against the ones with higher inflation rates.
 
Most currencies of developed economies, like USD, AUD, CAD, GBP, and many others have very similar average inflation rates around 2 to 3%. Global pandemics, wars, food and energy shortages, recessions, and economic crises are the main enemy of a stable economy. The main reason why central banks exist is to protect people from high inflation. High inflation makes calculations difficult for businesses, and productivity decreases. Many businesses are forced to increase prices on goods and services, when prices become too unbearable, consumers start spending less. Consequently, businesses close, products are no longer created and people lose wealth. Understanding CPI meaning in Forex is highly important as it will help you conduct better fundamental analysis.
 Using the Consumer Price Index
 

CPI and Interest Rates

While inflation usually urges central banks to increase interest rates, this is not always what follows high inflation. Increasing interest rates is bad for the economy, and therefore, central banks avoid such practice unless they have no other option left. Increased interest rate means that loans are getting more expensive. As a result, people take less money from banks. They have less money to spend on goods and services, and businesses suffer. High interests hurt the economy. 

How to use CPI (Consumer Price Index) in Forex trading

There are several ways and applications for CPI in FX trading:

Researching the historic relationship between CPI release numbers and Forex short-term price reactions

With this method, traders have to analyze the historic relationship of how each CPI release affects the price of FX pairs in a short period. The only way to achieve this is to write down the release dates for the previous period, visit the charts for the preferred currency pair, and see how prices reacted to CPI's positive and negative numbers. This is a longer and more complicated method and requires significant time and effort, but can be extremely rewarding for developing a profitable CPI-based news trading strategy. The same research method can be applied to all major economic indicators that impact short-term price movements in FX markets. 

Interest Rate Expectations Strategy

While similar to the first method, it is a slightly different approach. Traders will have to keep an eye on CPI releases. Central banks usually use CPI to understand inflation levels. If the CPI index deviates from the Central Bank’s target, it signals future changes in interest rates. The one potent tool used by central banks for controlling inflation is interest rate decisions, and if the inflation figures are too high they will have to intervene and change interest rates. This is a good indicator for traders to anticipate and use it for their decision-making.

High CPI typically signals interest rate hikes. If interest rates are expected to rise, the currency will be strengthened. 

Core CPI vs. Regular CPI method

Differences between the Core CPI (excluding Food and Fuel) and regular CPI might give insightful information to traders, as Core CPI frequently provides a clearer picture of real inflation. Analyzing Core CPI can provide information about underlying inflation trends, and it is less volatile than regular CPI. This way, traders can use a more conservative approach and trade with more stable indicators. However, more risks mean more potential gains, and the power of regular CPI can not be underestimated. 

Long-Term Inflation and Currency Stability Strategy

Now, this strategy can be considered a proper fundamental trading strategy that uses a few fundamental factors. Fundamental traders will assess the long-term impact of CPI on exchange rates by taking into account the Purchasing Power Parity theory. As we can see, this method is more aimed at experienced traders who have backgrounds in the economy. Stable inflation rates contribute to a stable economy and exchange rates, and countries with highly inflationary currencies can be a great target for fundamental traders. They can sell the weak currencies against the strong ones and make profits in the process. This strategy is not short-term, and it might take months for each position to be closed.

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Using the Consumer Price Index – Key Takeaways

How does consumer price index affect Forex

  • CPI is a good measure of inflation, as it's calculated based on a basket of consumer products. Each country has its own method and basket of products, as consumers buy different products from country to country. Most CPI baskets include food, housing and transportation prices. 
  • Most major Central Banks around the world actively target the level of inflation, therefore the latest releases of CPI can have a significant impact on their decision-making process. However, keep in mind that high inflation will not always lead to increased Interest Rates.
  • The deviation of CPI from the target rate of the Central Bank is an important factor for future policy. For example, the Federal Reserve, which aims at 2-3% annual inflation, is more likely to act if CPI hits 4% or higher. However, central banks generally hike interest rates as their last resort. High rates decrease money in everyday people's pockets, they have less to spend, and businesses find it difficult to sell. High rates decrease economic activity.

FAQ: CPI Forex indicator

What is the Core CPI and how does it differ from the regular CPI measure?

Calculating the Consumer Price Index differs from the Core CPI, in a sense, that the latter measure excludes Food and Fuel categories. The reasoning behind this is that the prices of those types of goods are very volatile. Removing these two categories could be helpful in indexing the CPI dynamics more clearly.
 
The Economist’ publishes it every single year since 1986, so it can give us some rough idea of its price dynamics.
 
During the first year of its existence, the index showed that the average price of a Big Mac in the largest US cities was $1.60. The latest 2020 report put the cost of the same item at $5.67. This shows the average annual inflation of 3.79%, again slightly higher than official CPI data.

How do the alternative measures of inflation compare with CPI data?

The Billion Prices Project tracks the prices of more than a thousand retailers. According to its website, in the US, from 2008 to 2016 its price index showed 2% higher cumulative inflation, than official CPI figures. This represents less than 0.25% difference on annual bases.
 
Some famous financial experts like Peter Schiff also referenced the Big Mac Index. This measures the average price of this burger in the four largest US cities and also in other countries. He pointed out that since this product includes the prices of bread, beef, cheese, vegetables, labor, transportation, and rent, it can be used as an inflation measure. Schiff also explained that the basket of those goods and services remains fixed and does not change constantly as CPI.
 
The ‘Economist’ publishes it every single year since 1986, so it can give us some rough idea of its price dynamics.
 
During the first year of its existence, the index showed that the average price of Big Mac in the largest US cities was $1.60. The latest 2020 report put the cost of the same item at $5.67. This shows the average annual inflation of 3.79%, again slightly higher than official CPI data.

Why does USD have a tendency to appreciate against some emerging market high yielding currencies?

Everything else being equal, higher-yielding currencies attract more demand and have a good potential for appreciation. The problem with some emerging market economies is twofold: Firstly, usually they have a much higher rate of inflation, which negates most of the potential gains.
 
Another major issue is political, economic instability and as a result, lower credit rating. Because of those two long term factors, USD does appreciate against some high yielding emerging market currencies.

Do all Central Banks target a 2% inflation rate?

Not all Central banks are aiming at exactly 2% inflation. For example, the Reserve Bank of Australia has a target range from 2 to 3%. Both Russian and Indian Central Banks are aiming for 4% annual CPI increases. The Reserve Bank of New Zealand supports a target range of 1 to 3%.

If the US has a 3% long term average inflation, then why is USD still used as a store of value by many citizens across the globe?

According to the Federal Reserve Bank of Chicago, more than 60% of all US bills are circulating overseas, including nearly 80% of all $100 notes. So what is the reason behind this demand? Doesn't USD on average lose 2 to 3% purchasing power per year?
 
Actually, in countries, where the economic or political crisis could lead to a collapsing currency, where half of the consumer’s savings can be wiped out in a matter of months, it does not sound like a bad deal. Being assured that your financial reserves could maintain at least 97% of their buying power is a luxury under those circumstances.

Emerging market investors can also make up for those theoretical losses with Real Estate, Stock Market, and other investments.
 
In this regard, USD and EUR are the most popular choices. Obviously, there are some other currencies with even lower average inflation, like Swiss Franc or Japanese Yen. However, there are several problems with those.
 
Firstly, in many countries, they are not always as readily available as the US dollar. Also, sometimes the spreads on those currencies are rather large, with customers losing as much as 5% for each transaction, when at the same time USD and EUR are available at much more reasonable rates, because of their widespread use.

What is CPI in Forex?

CPI in Forex stands for Consumer Price Index and is calculated based on a basket of products that are consumed regularly by everyday people. CPI is the main measure of inflation. Every country has its own basket. The USA CPI basket includes: Housing expenses, Food and Beverages, Transportation, Medical Care, Recreation, Education, Apparel and other goods and services.

How does CPI affect the Forex market?

CPI can have a different short term and long term effect. Short term effect is highly unpredictable. In general, news trading is highly unpredictable and requires special trading strategies that help catch sharp price movements. CPI's long term effect is related to interest rates. For the economy, stability is the most important as it creates the best environment for business to produce. Products are the real wealth and not the money. By printing more money, banks will simply increase the inflation. Which is why the main purpose of central banks is to keep inflation in a stable and low range. When CPI is larger than Central Bank targets, central banks try to increase rates (not always) to limit money supply and make currency stronger. Increased interest rates slows down the economy and is bad for business as people have less money to spend.

How to trade CPI in Forex?

In order to trade CPI, it's essential to take it into a context. High inflation means that the economy is not in a good shape. To fight inflation, banks raise interest rates, which has a short term effect and makes currencies stronger. However, the economy suffers in the longer term. People have less money to spend and businesses close. Closed businesses lead to weaker currency.
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