What is the Consumer Price Index (CPI)?
This economic indicator tracks variations in the general level of prices of goods and services acquired, used, or paid for by a reference population through time. Goods and services relate to day-to-day consumption expenses and therefore do not include investment items. The consumer price index (CPI) is therefore a weighted average basket of goods and services purchased by households. CPI measures the purchasing power of the individual consumers currency. CPI gives an indication of inflation as experienced by consumers. It is therefore one of the major items on a Forex Economic Calendar to keep an on.
In our previous article regrading the producer price index (PPI), the price paid by producers will logically be passed onto the consumer. Thus, PPI has a predictive power when it comes to price increases, but the true indicator is represented by the prices consumers pay, namely, the consumer price index. This indicator can cause large market movements and is normally released half-way through the month as an indexed number.
The question that naturally arises when hearing this is, wouldn’t these two numbers be the same or at least move in tandem with one another? The answer to that question is not necessarily, for the following reasons.
- The PPI is designed to measure the entire marketed output of producers which includes foods and services purchased by other producers.
- Imports are excluded from PPI, but included in CPI.
- Taxes paid as part of purchasing price by the consumer are not included in PPI but are included in CPI.
The important thing to understand is that a rise or fall in the PPI does not necessarily mean the same rise or fall in CPI. As this is the case the best measure for inflation is thus the end price consumers pay.
In addition to showing fluctuations in price for different areas of the country, the CPI also shows the fluctuation in price for different groups of products such as housing, transportation, medical care etc. This allows online traders to see not only the price fluctuations of the overall economy, but also for different areas of the economy.
The core CPI is the most widely followed number as it excludes the volatile food and energy sector.
To summarise, CPI is interpreted as a measure to calculate and monitor inflation. Inflation has the following three main negative effects.
- Distorting the behaviour of households and firms because it obscures relative price signals.
- Creating uncertainty and discouraging investment because it’s not precisely predictable.
- Redistributing income from creditors to debtors and fixed income earners to variable income wage earners.
How does the Consumer Price Index (CPI) affect you as a Forex Trader?
Forex traders keep an eye on the CPI because it can lead to changes in the central bank’s monetary policy, which can strengthen or weaken the currency versus rival currencies in the market.
The CPI is the most extensively used inflation statistic. Inflationary pressures force the central bank to hike interest rates. If CPI rises, it provides the essential evidence for a central bank, like the Fed, to raise interest rates. The country’s currency benefits from higher interest rates. In other words, if CPI is higher than expected upon release, the dollar will rise. If the indicator is lower, the dollar will decline.
In most cases, the second CPI effect on forex takes longer to appear. According to the purchasing power parity, in the long term, currencies with low inflation tend to appreciate compared the ones with a higher rate of price level increases.
To conclude, online traders should consider the impact CPI is likely to have
If CPI increases, interest rates will increase and the dollar will strengthen. Higher interest rates mean falling bond prices. Lastly, higher than expected inflation negatively impacts share prices due to the increase in interest rates.
The best way to learn how to anticipate market reaction under different scenarios with this number, is to follow several releases.