The Impact of Inflation Measures on the Forex Market

Inflation has long been a serious enemy to economic growth and the world's central banks constantly try to keep inflation in check by adjusting monetary policy. Inflation can influence currency exchange rates considerably, and the perception of inflationary trends makes up one of the basic items affecting central bank monetary policy.

Inflation can perhaps be most basically described as what results when too many dollars start chasing too few goods. This represents an oversimplification of the issue, but it does give an idea of the nature of inflation, which generally signals not the increase in worth of goods, but the declining value of the paper money used to buy those goods.

Because inflation affects all levels of society and the totality of consumers in an economy, it makes up one of the most important economic indicators to central banks and forex traders alike.

In addition, many large central banks such as the U.S. Federal Reserve have an obligation to keep inflationary forces at bay. As a result, they may raise the level of short term interest rates to contain inflation. In addition, they might lower these same rates to counteract deflationary tendencies and to stimulate the economy by making money easier to borrow.

The following sections describe various methods of assessing inflation levels used by fundamental analysts with a focus on the U.S. economy, as well as the impact that inflation controls can have on the forex market.

Effects of Inflation in the Forex Market

Central banks tend to fight inflation by adjusting interest rates as a key part of their economic control policy. In this way, central banks indirectly affect wholesale and consumer prices. These in turn affect the value of the nation's currency, and as a result, the level of economic activity in the country.

Because of the way that inflation affects interest rates, when an economic number indicative of inflationary trends is released that points to an increase in inflation, this will usually be bullish for the currency of that nation. This effect arises because interest rates would tend to be adjusted higher to fight this inflationary tendency.

Conversely, if the number indicates a decrease in inflation, this will tend to put downward pressure on the currency, because interest rates would be adjusted lower as a result.

The U.S. Consumer Price Index

A standard gauge of inflationary pressures in an economy consists of reviewing changes in the level of consumer prices. In the United States, the inflation indicator most commonly watched by forex traders is known as the Consumer Price Index or CPI.

The CPI is released monthly by the U.S. Bureau of Labor Statistics. This indicator is also known as "headline inflation", and its release is generally between the 13^th and the 19^th of each month.

Calculating the Consumer Price Index involves taking the weighted average pricing of a fixed basket of consumer goods and services, with each product in the basket assigned a fixed weight depending on the importance of the item. Consumer goods and services in the CPI include among others: food, housing, clothing, education, transportation, medical care, education and recreation.

An additional related number, the Core CPI, uses the same weighted average scale as the CPI, but excludes food and energy prices from the calculation to give a more accurate measure of inflation without these volatile components which tend to make up a quarter of the regular CPI.

Core CPI is typically more important to traders and the Federal Reserve as a measure of actual inflation since it tends to provide a more representative view of the inflationary forces acting in the U.S. economy.

The Chain Price Index and the Personal Consumption Expenditure

Another less popular but also significant index for inflationary trends in the United States consists of the Chain Price Index for Personal Consumption Expenditures, or the PCEPI.

This index is released monthly by the Department of Commerce's Bureau of Economic Analysis and forms part of the personal income report. The PCEPI has less of a forex market impact than the CPI because it is considered more predictable and so it tends to present less risk of a surprise to the market when it gets released.

Furthermore, the PCE or Personal Consumption Expenditures number measures the changes in prices of consumer goods and services which are affected by inflation by examining household expenditures.

The Chain Index part of the PCE calculation considers the varying level of consumer consumption based on price moves, and so provides another useful inflationary measure for the U.S. economy.