Inflation or the CPI (Consumer Price Index) is one of the most important economic releases. If not the most important one.
During a trading month, the economic calendar is filled with data. Traders use the data to interpret an economy.
Next, based on the economic differences between two economies, they sell or buy a currency pair. For example, if the U.S. data comes out stronger than expected, traders will buy the dollar.
But, there is so much economic data to be released on a monthly basis, that traders get confused. What matters the most for a market?
The answer to this question comes from knowing what matters for a central bank. Knowing what a central bank targets helps traders filtering the economic data.
A Central Bank’s Mandate
Central banks around the world have a clear mandate. Most of the times, it relates to inflation.
As such, a central bank’s goal is to create inflation. However, not by all means. Moreover, not any kind of inflation is desired.
For an economy to grow at a normal rate, inflation must sit around 2%. So, central banks in major economies around the world target the 2% level.
A normal central bank’s mandate looks to bring inflation below or close to 2%. Any move lower will be met with easing policies. Any move higher, with tightening ones.
The more inflation deviates from the target, the more aggressive the central bank’s actions will be. Recently, inflation declined on a global scale.
Oil and Inflation Expectations
A major source of inflation is the oil price. As a rule of thumb, when oil falls, inflation declines all over the world.
And, the other way around is true as well. When the price of oil rises, inflationary pressures pick up too.
The recent years showed the oil price moving aggressively lower. From values above $100 to around $30. In a matter of months, inflation fell in major economies around the world.
So dramatic the move lower was, that it reached negative levels in most economies. In the Eurozone, for example, deflation (when inflation moves below zero) appeared.
A central bank has only one way to respond to such conditions. To cut rates and ease monetary policy.
So, the ECB did just that. It cut rates all the way down to negative territory. And, it eased the monetary policy by starting a bond-buying program.
Even to this day, the program still runs. While inflation picked up a bit, it still rests well below the ECB target (below or close to two percent).
Why Do Forex Traders Care?
Traders always look for clues about what the central bank will do next. That’s what matters in Forex trading: the interest rate level and the monetary policy changes.
Inflation, or the CPI, is the one release that tells what the central bank will do with the rates. As such, traders expect the CPI data and position for the central bank’s decision.
That’s fundamental analysis in Forex trading. And inflation is the most important economic news to watch.
Forex traders mark the CPI releases on the economic calendar. When CPI gets out in UK, Eurozone, Japan, the United States, Australia or New Zealand, volatility is on the rise.
The more important the economy, the bigger the expected volatility is. The more the actual release differs from the expected one, the bigger the volatility.
All in all, when Forex traders look for clues about future interest rates, they look at the CPI level. That’s all that matters for most central banks.