Effect of inflation/consumer price index in Forex trading

Inflation rates and the Consumer Price Index (CPI) are major economic indicators which have a direct impact on the forex markets. The CPI is a key determinant of the level of inflation in an economy and is calculated by taking a household “basket of goods” and comparing the value of these to a previous period. If the value of these basic goods can be seen to increase, for example the cost of milk and bread, then this provides the basis for the economy’s rate of inflation. For forex traders, rising inflation is then seen as an indicator that there is surplus money in the economy which the central bank, or interest rate decision-makers will try to reduce. The most effective way to reduce inflation will be to increase interest rate which in turn lowers borrowing and creates demand for this excess money to be stored away in bank accounts to accrue favourable interest.

The CPI and how it affects inflation

The consumer price index is an important measure for both governments and traders in its effect on currency values. Whilst inflation itself, caused through the rise in the CPI, is not necessarily negative for an economy in the short term, the longer-lasting effects can potentially be very damaging. Booming economies tend to experience inflation which, left untouched, results in a decrease in the competitiveness in terms of international trade.

Within the CPI index, there are a wide range of goods which are weighted in regards to their importance. These include goods such as transportation, food, housing, medical care and leisure to form the “headline inflation” rate. Some of the goods incorporated in the CPI Index also highly susceptible to volatile changes in value, such as energy and agricultural foodstuffs, and these are excluded in the US from the ‘Core CPI rate’ which acts to reduce the impact of price shocks on the CPI index rate. Both of these figures are released in the US around mid-month and are normally expressed as an increase or decrease in percentage terms. As with other key economic indicators, analysts create benchmark estimations prior to the release of this data and figures above or below these have a highly influential effect on forex markets. Figures arriving above expectations have a tendency to increase the value of a currency as it increases the likelihood that inflationary pressure will result in a rise in interest rates.

Inflation, unemployment and how these influence forex trading

Inflation caused by rising CPI data puts considerable pressure on Central Banks and Federal Reserves to raise the rate of interest. Policymakers at the central banks are also aware that the result of this is that the value of the currency will appreciate as investors and speculators are attracted to these higher returns. Inflation also has a directly inverse relationship with unemployment and in reducing one the other will invariably rise. The reason for this is that reducing inflation in an economy makes companies appear to be earning less in real terms and they are therefore unlikely to increase their workforce. Since unemployment and inflation are both used by forex traders to indicate future interest rate activity, they are seen as two of the key indicators for currency speculators to use in anticipating increases or decreases in the value of currency pairs.

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