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 which composes 15% of the index.
- The transportation sector, having approximately 15% share in CPI.
- Medical Care
- 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.
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.