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 during the last 12 months. The exact composition of items and methodology of calculations does vary from country to country. However, CPI is still considered as one of the most important measures of inflation.
 
For the regular trader at Forex Markets, following the latest developments in the Consumer price levels can be useful in two ways.
 
Firstly, it is worth keeping in mind 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.
 
The second 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 which composes 15% of the index.
  • The transportation sector, having approximately 15% share in CPI.
  • Medical Care
  • Recreation
  • Education
  • Apparel
  • Other Goods and Services
 

How is the CPI Calculated

 
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 important economic indicators. In fact, like many other Central banks, the Federal Reserve targets 2% inflation in the medium term.
 
There is an obvious question: why exactly 2% and not some other number? 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 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.
 
So as we can see there are plenty of examples when the Central Banks do respond actively to the changes in the Consumer Price Index. This indicator gives an opportunity to traders to formulate the basic strategy.
 
For example, when the latest report of UK CPI comes out, if it is 1% or lower, then this might be a sign that in the future the Bank of England might be more likely to cut interest rates further and may even decide to expand Quantitative Easing. Those policies can certainly weaken GBP/USD, GBP/JPY, and other Pound related currency pairs.
 
On the other hand, if CPI is at 3% or higher, then the BOE board members might be more inclined to hike rates and by implication, strengthen Pound.
 
Obviously, 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.
 

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%. However, there are some exceptions to this. Since 2000, the Japanese CPI increased only by 3.03%, that’s only 0.14% per year. During the same period, Swiss inflation has risen by 8.89% in total, an average of 0.43% per annum.
 Using the Consumer Price Index
 
So why does this make any difference in Forex? To understand this, let us take an example. Suppose that at the beginning of the year USD/JPY stands at 100. One good, say the box of cartridges, is available for export from both countries. In the US it costs $100 and in Japan - ¥10,000. Therefore, at those exchange rates, the price is essentially the same in both places.
 
Then one year passes, the US CPI has risen by 3% and in Japan, this indicator remained at 0%. As a result in America, the price of this box of cartridges is now $103, when at the same time it is still possible to get this item from Tokyo for ¥10,000.
 
Finally, let us suppose that some large firm has to import 5,000 of those boxes for its offices. Since now each unit is $3 more expensive in the US, then why does a company spend an extra $15,000 when it is possible to save this amount by importing it from Japan?
 
Now, this won’t be the only firm or individual who sees this, so the demand for cheaper Japanese goods will increase until JPY does not appreciate by 3% and prices of goods in two countries once more get equalized.
 
This is why the inflation differentials might make a little difference in a short time horizon, but in the long term, it can have a significant influence on the exchange rates. Just to consider one example, from January 2000 to March 2020, the Swiss Franc has appreciated against the US dollar by 69%, which is a notable change.

 

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Using the Consumer Price Index - Key Takeaways

How does consumer price index affect Forex

  • 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.
 
  • 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% annual inflation is more likely to act if CPI hit 4% and may not consider any changes if it is just at 2.1%.
 
  • According to the Purchasing Power Parity, the exchange rates of comparatively low inflation currencies in the long term have a tendency to appreciate. This theory is mostly supported by the performance of CHF and JPY for the last couple of decades.


FAQ: CPI Forex indicator

What is the Core CPI and how it differs 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.
 
It is not surprising that some financial experts and commentators do not agree with this argument since it is hard to imagine any complete basket of goods and services without Food and Fuel items.
 
Despite those objections, the US Federal Reserve still gives a preference for Core inflation measures during its decision-making process.


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 of 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 of the 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? Does not USD on average lose 2 to 3% purchasing power per year?
 
Actually, in countries, where the economic or political crisis could lead to 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.

 

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