3 Reasons Why Inflation Matters in Forex Trading

The Forex dashboard consists of over twenty-something currency pairs. They represent combinations of currencies from around the world.

Each currency shows the strength/weakness of an economy. The stronger the economic performance, the stronger the currency is.

When the economic activity picks up, companies will expand their activity. They’ll start hiring more people and pay higher wages to compete on the jobs market.

As a result, people will see their month-to-month disposable income rising. In plain English, they’ll have more money left at the end of the month.

Spending rises. This, in turn, will put pressure on prices. Sellers will notice the stronger demand for their products and will ask more money for them.

This is how inflation appears. The definition here is simplistic but contains all the elements of an inflationary cycle.

For the Forex traders, inflation is the most important element that gives the direction of a currency. Here are three reasons why this is the case.

Central Banks’ Mandate

Central banks around the world have a mandate. Or, if you want, a job they must do.

Any mandate of a central bank that governs a capitalistic economy considers inflation. Some central banks have a dual mandate, like the Federal Reserve in the United States. Not only it looks at inflation, but also at job creation.

The typical inflation mandate calls for a normal level of inflation to be below or close to two percent. As such, 1.8% or 2.2% are normal levels.

Anything above will result in the central bank raising rates. Anything below will trigger rate cuts or easing.

Every trader in the world knows this equation. Or, at least, he/she should be aware of this correlation. Because this correlation gives great positioning for future trades.

CPI – Consumer Price Index Release

In economic terms, inflation is referred to as CPI (Consumer Price Index). It reflects the price changes of selected goods and services in an economy.

For Forex traders, the CPI release is a great opportunity to position for the central bank’s meeting. The thing is that the CPI comes out AHEAD of the central bank’s meetings.

In other words, a release that differs from the forecasted value will be enough for traders to position for the central bank’s next meeting. If the CPI disappoints, sell the currency as the central bank will have a dovish tone.

The opposite is true if the CPI exceeds expectations. Sometimes there are a couple of weeks until the CPI release and the central bank’s meeting. In other words, plenty of time to position on the right side of the market.

The Core CPI – Eyes on the Oil Market

Not all prices matter, though. Central banks prefer to look at real inflation or the “core” one. This release will focus only on the change in prices of goods and services except for energy prices, food, and sometimes transportation.

These are volatile and most of the times transitory. Hence, the data tends to be distorted.

Therefore, traders should focus on the core release, not the regular data. Sometimes, the actual inflation comes in line with expectations but the core release doesn’t. That’s when the market will move

Conclusion

For a currency, all that matters at the end of the day is the interest rate. Central banks set the interest rate, and they do that looking at inflation.

Knowing when inflation comes out and what data to consider is vital for Forex traders. Together with technical analysis, this information put a solid foundation ahead of every future trade.


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