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:
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
- 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%. 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 reaction 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 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 good and cervices, 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.
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.