What is the consumer price index, and why is it important for forex trading?

On a monthly basis, the US Labour Department releases consumer price index (CPI) figures, both including and excluding the volatile prices of food and energy. But why even analyze the CPI meaning? The CPI figure is meant to reflect the level of consumer inflation experienced by Americans in the last four weeks. The CPI’s method of achieving this is through calculating a weighted average price of a basket of goods and services, which helps us gauge how much price changes actually impact the cost of living.

What is a “weighted average”? Take a basket of items that typical households regularly purchase – for instance food, rent, clothes, transport, and medicines. In almost all cases, people devote more of their income to paying rent than buying medicines, so it makes sense to assign more weight to rent than medicines in the CPI calculation. That’s because a small hike in rental costs will have an outsized impact on the cost of living, whereas a large increase in medicine costs will have a comparatively small effect. The Labour Department – together with economists, traders, and political figures all over the world – want to get an idea, by means of the CPI, of how much rising prices are affecting average household costs.

When the CPI records a rise in inflation, it means that people will likely spend less – since their purchasing power is being undermined. They may put off large purchases and elect to save their money, especially if the US Federal Reserve hikes interest rates to address the inflation issue. (Higher interest rates mean higher returns on savings.) Plus, businesses may borrow less for expansion purposes when inflation heats up. All of this implies that the economy could slow down, and that’s why financial traders sit up and take notice.

In the forex market, participants watch the CPI figures like hawks, often reacting sharply to surprises in the data. Most of the time, a hot CPI print will translate into bullish action for the US dollar against its counterparts. The reasoning here is that, since inflation is so problematic, the US Federal Reserve will have to hike interest rates to contain it, and this will bolster the dollar against its competitors. However, in the event the market knows for sure that the Fed won’t be doing any hiking – let’s say because the Fed chairman recently called inflation “transitory” – the dollar pairs may not react in the same way. Let’s find out more about this topic – addressing such questions as “Is high CPI or good or bad in forex trading?” but also delving into some nuances of the CPI meaning in that context.

Is High CPI Good or Bad?

When forex traders react to high CPI numbers by buying the dollar, it’s not really true that they’re doing so because they believe the Fed will hike rates. Rather, they anticipate that the broad market reaction to the data will be bullish for the dollar, and they position themselves accordingly. That’s because what will drive the dollar higher is the fact that many market participants will actually go ahead and buy it. This is irrespective of whether or not they were correct in their assessment of future Fed policy.

Therefore, a savvy forex trader might know that the Fed won’t really respond to the CPI by hiking interest rates, but still elect to go long on the USD. The large mass of people who make up the forex market consists of, not just educated, informed participants, but also less informed retail traders who will not be able to read between the lines of the data. Plus, knee-jerk reactions to CPI reports are often sparked by computer algorithms, which may not account for extraneous knowledge about the Fed’s hiking plans.

Thus, the initial market reaction to a CPI report may be emotional and bullish, and this trend will be reinforced by those who jump on that train in order to reap earnings. However, the longer-term market moves will be driven by those who understand the real economic implications of the data, including large financial institutions. Consequently, a smart trader may decide to go contrary to the initial market response by shorting the dollar – in anticipation of the market correcting its first response.

How did Market Reaction to CPI Evolve?

We have said that forex traders approach the market through anticipating large-scale reactions and running with them. But does the market always respond in exactly the same ways to CPI data, whether for the bullish or the bearish? The answer is no. In reality, we see that the market often responds to the same sort of data in totally different ways. This implies a sober warning for those traders who automatically expect the dollar to rally when the CPI comes in high. But is high CPI good or bad?

In reality, the market’s reaction to CPI depends on the context. Let’s say we’re at the start of a Fed hiking cycle, when high inflation rates are just beginning to be addressed. When CPI surprises us to the upside, there is genuine reason to expect hawkish Fed policy, and thus to go long on the dollar. But compare this to the case where the Fed has already been hiking rates for many months, with weakening effects on the economy clearly evident. Hot CPI will trigger more worries about slowing economic growth than about Fed hiking. As a result, it’s very possible the market reaction to the data could be to sell off the dollar, pushing its value down. After all, a weak American economy spells weakness for the US currency.

Or, if the market has already priced in a strong CPI report before the release of the data, its release may not spark a very big reaction, even if it’s hot. Alternatively, if the market knows the CPI is elevated due to inflated energy prices, it may tone down its response. The point for forex traders to remember is that the market won’t react to the CPI figures based purely on the cold, hard data. The broader scenario determines whether or not a hawkish Fed reaction would be realistic. Smart traders observe the market’s fluctuating reactions to the same data and try to learn from them.

The Meaning of CPI in the Forex Market

We have learned why the monthly release of the CPI strongly draws the interest of forex market participants all over the globe. We have also learned about the nuances in reactions to the data release, depending on the context. For the budding forex trader, there is much to learn about trading the CPI report effectively.

Remember: While forex traders contribute to the shaping of exchange rates, they don’t determine them on their own. Central banks do. While emotional traders can exert a marked impact on currency values, this is usually only temporary. Fundamental factors like the Fed’s actual words and actions normally carry prices to their ultimate destination in the end. Your approach to forex trading with the CPI should depend on whether you’re focusing on short-term or long-term price movements.