The Consumer Price Index (CPI) is a broad measure of inflation within an economy in relation to the cost of goods and services. That figure can have a significant impact on the value of a currency in relation to the currencies of other nations.
The CPI calculates theweighted averageof prices of a basket ofconsumer goodsand services, including costs of transportation, food, and energy. Economists use this CPI figure to assess price changes in individuals’cost of living.
When inflation is too low, a central bank like the Federal Reserve may cut interest rates in order to spur economic activity. When inflation is too high, interest rates maybe raisedto stabilize prices. By increasing interest rates, a consumer may be more likely inclined to save money, rather thanspend it, due to the return they may generate by keeping it in a bank.
Key Takeaways
- Inflation, as measured by the CPI, can have a significant impact on the relative value of currencies.
- This is because inflation is a factor that the Federal Reserve considers when shaping monetary policy.
- When inflation is too high, the Fed may raise rates to encourage saving and cool spending.
- This then strengthens the dollar against other currencies, making it more desirable in the forex market.
In the foreign exchange(forex) markets, the monthly CPI measure is one of the most important indicators monitored by traders. In the case of the U.S. dollar, the release and revisions of the CPI figure by the Bureau of Labor Statistics can produce swings in the dollar’s value against other currencies around the world.
This article explains how CPI data affects the relationship between the dollar and its pairings with other currencies on the forex market.
Why the CPI Matters to Currency Traders
Markets typically refer to the CPI indicator as “headline inflation.” This CPI data is critical in the currency markets because inflation dramatically impacts the decisions made by central banks regarding monetary policy.
Given that central banks typically have a mandate to control inflation at a suitable level (the Federal Reserve and the Bank of Japan have both targeted an inflation rate of 2.0% annually), policymakers raise or lower interest rates as a mechanism to reach these target levels. They may also introduce other policy prescriptions such as bond-purchasing agreements or the expansion of the money supply.
Should inflation levels deviate from target levels, it is a possible indicator that central banks like the Federal Reserve may alter interest rates. If inflation rises above that 2.0% target, the Fed may raise interest rates in order to cool down spending. That will strengthen the dollar against other currencies as a higher interest rate makes the greenback more desirable.
It is also a forward indicator of an economy’s performance. Should inflation rise sharply as it has in countriessuch as Brazil and Venezuela in recent years, consumers will be less inclined to save money as their purchasing power erodes.
Meanwhile, when a central bank hikes interest rates to combat inflation, borrowing, whetherby individuals to purchase goods and services or by businesses for the purposes of expanding, will typically contract. This can impact the broader gross domestic product of a nation.
How CPI Data Affects the Dollar on the Forex Market
The Federal Reserve has a dual mandate that affects its actions on monetary policy. The central bank wants to bring the economy to full employment and it wants to ensure a healthy rate of inflation as the economy expands.
As a result, forex traders see both unemployment and inflation figures as figures that will dictate the central bank’s future decision on whether to cut, raise or maintain current interest rate levels. Given the impact of an interest rate on the strength or weakness of a currency, traders can anticipate the impact of the central bank’s actions and the impact on the dollar’s performance in currency pairs.
Forex traders consider the CPI and Core CPI figures to be two of the most fundamental indicators for the performance of an economy. Between the two, however, the Core CPI figure provides a better look under the hood by excluding costs in the energy and food sectors, which tend to experience greater price volatility over time.
In the United States, the Labor Department releases the CPI and Core CPI figures, which don't include the costs of energy or food in the measure. Should that number beat market expectations, the dollar typically sees a boost against other currencies. However, should these readings fall short of consensus expectations, the currency will fall relative to other pairings.
However, the impact is not limited to the monthly report. Like all government data figures, the CPI figure is subject to revisions by economists. Such changes can fuel significant volatility in a currency's value on the global market.
How Does Inflation Affect the Dollar?
Inflation is a phenomenon in which the price of goods and services increases over time. When this happens, money loses its value. Inflation's impact on the dollar lies in the gradual erosion of its buying power. In simpler terms, this means that a dollar in your pocket today is worth more than what it will at a date in the future, assuming steady inflation.
How Is Exchange Rate Affected by Inflation?
When inflation is high, it weakens a currency because buying power has reduced. This in turn suppresses investment. This can negatively impact a country's exchange rate. The inverse is also true: When inflation is low, a currency is relatively strong, which has a positive impact on its exchange rate. However, it's critical to remember that there are plenty of other factors affecting exchange rates, including balance of trade, debt, interest rates, and more.
What Happens When CPI Is High?
When inflation rises above the 2.0% target, the Fed may elect to raise interest rates to incentivize saving. These higher interest rates may then draw foreign investment, increasing the demand for and value of the U.S. dollar.
The Bottom Line
The Consumer Price Index (CPI) is a critical indicator of pricing pressures in an economy and provides a gauge of inflation. Forex traders monitor the CPI, as it can lead to changes in monetary policy by the central bank that will either strengthen or weaken the currency against rivals in the markets. The strength or weakness of a currency can also have a significant impact on the earnings performance of companies with a presence in many global markets.
