When it comes to forex trading, many factors affect the decisions of the traders, investors, and brokers in the market. While some factors like political stability have an indirect impact on trade, some factors like the CPI measure have a direct and huge impact.
As a critical economic indicator of pricing changes in an economy, the CPI affects the inflation rates and consequently influences the decisions the central banks make regarding monetary policy. The CPI also acts as a performance measure of the economy, which means traders will often consult the CPI measure to make informed trading decisions.
But we are getting ahead of ourselves. First, let us define what the CPI is and why it matters to forex traders.
What is CPI and Why it Matters to Forex Traders
Consumer Price Index, commonly abbreviated as CPI, is an economic measure used to examine the cost of living by tracking the level of inflation. Also referred to as “headline inflation,” the CPI is calculated by taking a weighted average of the price changes of items in a predetermined basket of products.
This basket can include any consumer goods and services list, from food and transportation to medical care and housing.
Once the CPI has been calculated, the figure is compared to the previous CPIs. Changes in the CPI are used to identify periods of inflation and deflation and later to assess the cost of living.
CPI is released every month, although some countries release it on a yearly or quarterly basis.
Why CPI Matters to Forex Traders
As a measure of inflation levels in consumer goods, the CPI has a significant influence on the monetary policy decisions made by central banks. Like the interest rates decisions, some of these decisions have a direct impact on the strength of the currency in the forex markets.
Interest rates go hand in hand with inflation rates. When inflation rates go above or below the target levels, the banks have to decide on how to alter the interest rates so that the economy is stable.
If the inflation levels fall too low from the target inflation level, the central bank might lower the interest rates to increase the level of economic activity. On the other hand, if the inflation levels are too high above the target levels, the central bank might increase the interest rates to reduce the consumers’ purchasing power.
When the interest rate of a particular currency hike due to increased inflation rates, the demand for that currency increases, and the currency becomes stronger. Similarly, when the interest rate drops, the demand for that currency reduces, and its value becomes weaker.
How CPI Data affects the Dollar on the Forex Market
The Dollar is not only one of the major currency pairs in forex; it is the most traded currency. As the most traded currency, anything that affects the Dollar ultimately affects other related currency pairs.
The CPI, which has a direct relationship with the Dollar, has a significant impact on the value of the Dollar. When the CPI goes down, the value of the Dollar goes down. Similarly, when the CPI rises, the value of the Dollar rises. This is because an increase in the inflation rates causes the Federal Reserve to increase the interest rate, which increases the demand for the US Dollar.
Because of the effect, the CPI has on the Dollar’s performance, forex traders anticipate the release of the CPI figures and the interest rate decisions that the Federal Reserve makes as a result of them.
The CPI figures, which are released by the Bureau of Labor Statistics, are divided into two – the CPI and the Core CPI. The difference between the two is that while CPI includes all consumer goods and services, the Core CPI excludes energy prices and food prices because of the high price volatility both commodities experience.
Once the CPI figures are released, economists measure the number against market expectations. If the CPI figures are higher than the market consensus expectations, it means that the Dollar has increased in strength as compared to other currencies.
On the other hand, if the CPI figures are lower than market expectations, it means that the value of the Dollar has reduced as compared to other currencies.
How to trade with the CPI Data Releases
When data for the CPI is released, forex traders make trading decisions based on the data. The main thing traders look at in the data is the market expectations for inflation and how they will affect the currency’s strength. This information will later determine whether the traders buy or sell currency pairs associated with the particular currency.
There are two ways to examine the market expectations of inflation from the CPI. One way is to compare the forecasted figures and the previous figures with the actual release figures. In this way, the traders examine whether the actual CPI release meets the predicted market expectations and whether it has increased or decreased from the previous figure.
For example, let us say traders expect the EU to release their monthly CPI figures. The market forecasts that the CPI will be 1.6%, and the previous month’s CPI figure is 1.4%. When the actual CPI is released, the traders will compare the figure against the forecasted figure and the previous figure.
If the figure beats the forecasted and previous value, the traders will expect the European Central Bank to raise their interest rates, and the demand for EUR will increase.
On the other hand, if the figure is lower than the forecasted figure and even lower than the previously released data, the traders will expect the European Central Bank to lower their interest rate, and the demand for EUR will reduce.
Another way to interpret the CPI is to look at the central bank’s target expectations and use the information to determine whether the interest rates will increase or decrease.
For example, let us say the Federal Reserve target inflation rate is 1.8%. If the inflation rates drop and miss the central bank’s target of 1.8% in the following months, traders will expect the central bank to lower the interest rates and will not buy USD.
But if in the following months the inflation rates rise and meet the central bank’s target of 1.8% in the following months, the traders will expect the central bank to hike their interest rates and buy USD.
Both of these methods of interpreting CPI provide forex trades with trading opportunities and allow them to try new trading strategies. However, traders should be aware that not every fundamental analysis of the CPI will work out as expected.
Before making trading decisions, the traders should take a few minutes to observe if the price movements have rebounded off any important areas. This will prevent losses that might result from a short-term currency strength and help the traders make informed trading decisions.
The CPI affects the inflationary pressures and the interest rates decisions and affects the fiscal policies, stock indices, and the domestic economy in general. In any financial market, economists keep track of the CPI release dates in an Economic Calendar.
That way, they can be able to make informed trading decisions of a basket of products they might want to trade-in.
In forex trading, broker companies like Tixee are equipped with complex instruments and tools that help traders capitalize on the CPI and make profits.
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Disclaimer: This article is not investment advice or an investment recommendation and should not be considered as such. The information above is not an invitation to trade and it does not guarantee or predict future performance. The investor is solely responsible for the risk of their decisions. The analysis and commentary presented do not include any consideration of your personal investment objectives, financial circumstances or needs.
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