Intermediate

Fundamental analysis

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Inflation and CPI

2.5-minute read

Inflation is a crucial factor in economics and plays a key part in fundamental analysis. Let’s take a closer look at what inflation, hyperinflation, and deflation all really mean, and how inflation is measured.

As we covered in the previous lesson, central banks must maintain a tricky balancing act. Most have a dual mandate of maintaining high employment while keeping prices stable – and to keep prices stable you need to manage inflation.

What is inflation?

Inflation is the term for when prices rise over time in an economy. It gets its name because prices are being inflated higher each year, just like blowing up a balloon.

While rising prices might seem like a bad thing, they are part of a growing economy. Most economists today believe that a low and stable inflation rate can help reduce the severity of economic downturns by providing a cushion against falling prices, which can be difficult to manage if they become entrenched.

For this reason, central banks will try to keep inflation within acceptable parameters. The Bank of England, for example, has a target of 2%. This means that prices overall should increase by 2% each year.

If inflation drops below 2%, it may consider lowering interest rates to boost the economy and get it back on track. If it goes too high, they could raise rates to slow the economy. Otherwise, they run the risk of hyperinflation.

Illustration showing example of interest rates vs inflation dynamics

What is hyperinflation?

Hyperinflation occurs when inflation gets out of control. Prices get too high, and the value of currency plummets. Classic examples include Germany before WW2, Russia after the fall of the Soviet Union and Zimbabwe in the mid-2000s.

FXUS-SC9-HyperinflationChart

Usually, hyperinflation leads to a total loss of confidence in an economy and its currency, so central banks are constantly on the watch to avoid it. Some analysts argue that the rise in unconventional monetary measures – such as quantitative easing – in the 2010s could lead to hyperinflation by flooding the market with capital.

What is deflation?

Deflation arises when prices are declining – so inflation is below 0%.

To the average person on the street, deflation might seem like a good thing. Who wouldn’t want the things they buy every day to get cheaper?

Well, manufacturers and producers, for one. Deflation means that the margin they make from sales would go down, which hurts their bottom line and may lead to layoffs. As unemployment rises, demand falls, and companies are hurt even more. And what does this lead to? Even more job losses.

This is called a deflation spiral.

To avoid this spiral, central banks may consider easing monetary policy when inflation falls.

Deflation spiral graphic

Reflation and disinflation

These describe changes in the inflation rate:

  • Reflation is when the inflation rate is going up
  • Disinflation is when it is going down

In the 1990s and 2000s, the Bank of Japan struggled to reverse a stubborn disinflation trend. During this period, inflation remained low and the economy stagnated in a period known as the ‘lost decades’.

As 0% interest rates failed to kickstart consumerism or business activity, with the BoJ eventually turning to quantitative easing, in which a central bank buys bonds and asset-backed securities to increase money supply and introduce inflation.

What is zinflation?

“Zinflation” is the term we are using for when interest rates stay the same over a period of time. Back in the 1990s the idea of zinflation was something that was debated as being the ultimate goal of central banks and even Federal Reserve Chairman Alan Greenspan expressed a desire to achieve it. Since then, the experience of Japan in the Lost Decades has served to make zinflation less desirable, as it would be likely synonymous with lack of growth for an economy as well. Therefore, the model of low inflation near the 2%-3% level has become the preferred model to begin the 21st century.

What is the Consumer Price Index (CPI)?

The Consumer Price Index (CPI) is an economic indicator that tracks the cost of goods and services and serves as an important statistic for identifying inflation or deflation. Known also as headline inflation, it is a major influencer of interest rate changes based on the inflation targets set by central banks.

The CPI figure is calculated by weighting the average price of a basket of products across goods and services such as groceries, transport costs, and healthcare, and measuring their change in price over time.

When the amount of the currency needed to buy the market basket increases, this is inflation, and when the amount of currency needed to buy the market basket decreases, this constitutes deflation.

The core CPI figure is slightly different as while it still measures the change in price of goods and services, it does not include energy and food prices. These are omitted for this measure as such prices have the tendency to be highly volatile and therefore capable of creating a misleading impression of inflationary pressures.

When is CPI released?

In the US, the CPI is released monthly by the US Bureau of Labor Statistics and has been reported since 1913. However, in countries such as Australia, the data is released on a quarterly basis, and in Germany, an annual report is issued.

How the CPI affects forex

Higher inflation in the form of a higher CPI naturally makes an individual unit of currency worth less, as there are more units of that currency needed to buy a given item.

But more importantly, as with the NFP and GDP, when the CPI changes, central bank monetary policy may follow suit.

High CPI may inspire interest rate hikes by a central bank in an attempt to control the inflationary trend. When a country’s interest rates are higher, it is likely that its currency will strengthen as demand for it increases.

Conversely, lower inflation may lead to decreased interest rates and weaker demand for a country’s currency, prompting consumers to spend, putting more money into circulation, and generally stimulating a slower economy.

So given this information, it’s no surprise that when CPI data is released, forex swings can happen in kind. Sometimes it can create volatile conditions with extreme movement, creating potential for large profits, as well as proportionate risks.

CPI trading strategy

The Consumer Price Index can move forex, which means there are numerous strategies for trading it.

To trade the CPI, you’ll need to be aware of the expectations the market holds for inflation and the likely outcomes for the currency if these expectations are met or missed.

Sometimes, an environment for increased inflation will be welcomed (for example, when deflation is rife), while in more inflationary conditions an increased rate of inflation may be considered bad for the economy.

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Analyst expectations for inflation are released on a monthly basis, with their judgments based on supply and demand dynamics, currency prices, and key commodity prices, as well as fiscal and structural measures.

After the CPI release and surrounding analysis, you might want to bring in technical elements to your approach, examining if the price is reacting to key support and resistance levels. Technical indicators may help to give some insight into the short-term strength of the move, for more informed trading decisions.

However, as with other news releases, timing is everything. It may, therefore, be unwise to open a position shortly before an announcement, as forex spreads may widen substantially immediately before and after the report.

CPI example

In the below chart, US inflation statistics are shown as a percentage of change since the same point 12 months ago. So, for the March 2021 figure, consumer prices were 2.6% higher than at the same point the previous year.

US CPI figures

For US traders, the US Dollar Index (USDX), which shows the performance of USD against a basket of other currencies, can be a useful way of exploring the effects of CPI data. If the latest release is divorced from analyst expectations, traders may watch for USDX to move accordingly.

On the March 2021 CPI figures (which were released the following month), USD briefly spiked as the mark was slightly above analyst expectations. However, as it became clearer that interest rate hikes were likely off the agenda for 2021, the USDX fell, a slump aided by languishing US treasury yields.

CPI release impact on US Dollar Index

CPI takeaways for forex traders

  • CPI is a major indicator used for determining the rate of inflation
  • The measure helps central banks to maintain price stability
  • Significant forex swings can occur when releases don’t align with analysts’ expectations
  • Time your entries carefully so as not to get caught by widening spreads
  • Consider using other economic indicators in conjunction

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Test your knowledge

Question 1 of 3
How can QE increase inflation?
  • A By raising interest rates
  • B By increasing money supply in the economy
  • C By lowering demand for bonds
Question 2 of 3
A loaf of bread costs 50% more today than it did 20 years ago. Is this an example of…
  • A Inflation
  • B Deflation
  • C Hyperinflation
Question 3 of 3
A loaf of bread costs 500% more today than it did yesterday. Is this an example of…
  • A Inflation
  • B Deflation
  • C Hyperinflation
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