Fundamental Analysis – CPI and Its Importance in Forex Trading
Speculating on the currency market means buying or selling a currency pair with the intention of making a profit. This statement means different things for different traders, based on various factors, one of which can be the size of the trading account. It is proven that traders with small trading accounts have the tendency to risk more, as they can afford to lose the account; while traders with bigger trading accounts are more conservative. From this point of view, the first category of traders will engage in scalping techniques and may end up overtrading the account, while the ones in the second category will adopt swing trading techniques, and even look at the bigger picture to invest in the currency market.
Another way to make a profit in the Forex market is to trade the news. This is part of fundamental analysis, and even here traders are split into two categories. Retail traders, or the ones with a small trading account, will look at economic data as just an opportunity to add some quick pips in the trading account. While this may work from time to time, in the end it only takes one small mistake and the trading account is gone. Professional traders, such fund managers and the like, look at the economic data from a macroeconomic perspective: that is, comparing different economies based on the macro-picture, and taking a trade in the direction of buying or selling a currency based on their fundamental view. The time horizon for these trades is longer than in the case of retail traders, but these ones rarely end up on the wrong side of the market. Resources dedicated to a research trading department make all the difference in the world.
Previously in the articles dedicated to the fundamental section of this part of the Trading Academy, we introduced the economic calendar and its importance. As mentioned in other articles, everything on the economic calendar is about what a central bank is going to do with the interest rates and its monetary policy the next time its governing body meets. If, for example, one is interested in trading the euro, all the economic data as listed in the calendar is interpreted, considering what the central bank, in this case the European Central Bank (ECB), will do the next time the Governing Council meets. That’s it!
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What Matters for a Central Bank?
Having said all the above, the next thing traders do is to filter all the economic data about a currency. The filtering considers two central bank meetings. To be more exact, in the case of the ECB, the central bank meets on a Thursday, every 6 weeks. The task of traders will be to look at every piece of economic data in the calendar that is going to be released in the 6 weeks between the two central bank meetings. The ones coloured red are the most important ones, while the ones listed in orange and yellow are second-tier data. Nevertheless they all, when grouped together, allow one to make an educated guess about what the central bank is going to do at the next meeting. Will it change its monetary policy statement? Will it raise or cut the rates? Will it change the tone and language? The example above is about the ECB, but the same is valid for every major central bank. The RBA (Reserve Bank of Australia) meets monthly, on a Tuesday; the Bank of England (BOE) meets monthly as well, on a Thursday; while the Federal Reserve of the United States meets every 6 weeks, and so on.
Consumer Price Index (CPI)
On top of every central bank’s agenda is the CPI, or the inflation level. Changes in the inflation level make the central bank shift its monetary policy, from easing to tightening, from a dovish to a hawkish language, etc. This is because inflation is on the mandate of every central bank in the world, whether it is the entire mandate or only part of it. A classic mandate is to keep inflation below or close to 2%. There is a lively debate these days as to whether this inflation level is appropriate in the current times, but, until anything changes, we’re sticking to it, as it is the one that allows economies to grow at a normal pace.
To continue with the same European example, above is the inflation release in the Eurozone: the CPI Flash Estimate y/y. The y/y means that the piece of data is interpreted on a yearly basis. However, at the time of the release, monthly data becomes available as well. Changes in the CPI level will result in big swings in the currency market, namely in the euro pairs. The image above shows that this release was forecasted to come at 1.8%, with the previous figure being 1.8% as well. In other words, no changes were expected. Nevertheless, the actual number was 2% (the one in green). Inflation ticked higher, and this has consequences for the euro as a currency. Traders will look at this moment at the ECB mandate: to keep inflation below or close to 2%! By this judgment, the mandate is fulfilled, but the interest rate is in negative territory in Europe, and the quantitative easing programme is still running at a fast pace. Based on the inflation release, chances are that the next time the ECB meets the monetary policy will shift; if not by hiking the rates, then at least by changing the tone of the statement to a more hawkish one. As a rule of thumb, if inflation is rising, the central bank will become hawkish, and in the end, will start hiking the interest rates; while if inflation is falling, the central bank will become dovish and start cutting the rates. One week after the item of information presented above was released, the ECB met and changed the language to a more hawkish one. As a result, the EUR/JPY, EUR/AUD and EUR/GBP pairs were all traded higher. If you paid attention to the moment the rising trend started, though, it was not when the ECB delivered the hawkish statement, but one week earlier when the CPI on inflation was released. Those who knew what to look for had an early start on a profitable trade!
Sometimes central banks do not look at the overall inflation data, but exclude some volatile items from it. Such items are energy prices (oil, for example), food prices, and even transportation. It is well known that the Federal Reserve of the United States (Fed)’s favoured measure of inflation is the Core CPI. If that is not moving, the Fed will sit on its hands and won’t do anything. So far, we talked about central banks as the main drivers in moving a currency, and inflation as the first thing central banks look at before changing rates. Moving forward, we’ll look at other economic releases central banks consider, and hence are important for traders to form an idea about what the next move will be.
Recommended Further Readings
- Forex Trading – Explaining the Concept
– What is Forex trading? Generalities about trading the currency market.
- Pending Orders Explained
– Different types of pending orders; how to set them; where to find them on the MetaTrader platform, and much more.
- Forex Market Participants
– Who participates in the Forex market; its structure and componence; and implications of different groups.
- Financial Products to Trade
– Different categories of financial products that a Forex Broker offers for retail clients, starting with the classical currency pairs, and continuing with commodities, CFDs, indexes, etc.
- Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions, their importance and ranking, etc.
- Forex Brokers Types – ECN or STP?
– What are ECN and STP? How brokers deal with client’s orders; and advantages and disadvantages of the tw- types.
Other Educational Materials
- “Consumer prices, the consumer price index, and the cost of living.” Boskin, Michael J., Ellen R. Dulberger, Robert J. Gordon, Zvi Griliches, and Dale W. Jorgenson. The Journal of Economic Perspectives 12, no. 1 (1998): 3-26.
- The consumer price index as a measure of inflation. Bryan, Michael F., and Stephen G. Cecchetti. No. w4505. National Bureau of Economic Research, 1993.