Using fundamentals in practice.
Inflation is one of the most important fundamental indicators in any country. Therefore, each trader needs to understand exactly how it affects the rates of various currencies, and how to use this data to build own forecasts.
Some traders – even experienced ones – believe that since they are engaged in scalping and open dozens of short trades during the day just watching the chart moving, they do not need to know anything about Inflation. But the thing is that they need to keep an eye not only to such key data but the other news from the Economic calendar as well! Remember that any changes you did not have time (or did not want) to pay attention to may adversely affect even your short-term trading.
Primarily inflation reflects changes in prices for goods and services in the country. Therefore, it is strongly associated with the value of the national currency (its course fluctuations).
The economists usually inspect the inflation at both the Consumer and Producer levels; separately are indicators of the real estate area. Consumer Price Index (CPI) is often calculated monthly (less often – quarterly) and published in the Economic Calendar. It shows how prices have changed for a certain “customer basket” of goods and services. Among the set of the inflation’s indicators, consumer data is the most important in comparison with the same producing indicator (PPI), which has a little effect on the exchange rates changes in the usual situation and is considered as the second-level indicator.
PPI is considered as an early indicator of inflation. It is logical that a rise in producer prices will ultimately affect the cost of services. Therefore, abrupt changes in PPI values may provoke noticeable upward or downward national currency course movements if they turn out to be stronger or weaker than expected.
The logic is as follows: the acceleration of inflation is a sign to the economy overheating. So, the Central Bank will be forced to respond with the rates increase: even the prospects for their boosting in future can support the national currency course. Conversely, the weakening of inflation is the reason for the policy softening and the quotes lowering as a result.
Let us explain. An interest rate is a tool by which Central banks regulate the direction of the country's monetary policy and make it more (or less) profitable to receive the credit from the government.
Remember: inflation is the reason why central banks could decide to change the interest rates level.
In developed countries, a normal level of inflation is considered to be 2% or slightly lower. For developing countries, this figure is about 4%. These benchmarks are central banks required to take into account in the medium term.
As a rule, a sharp growth and forecasts that inflation will continue to rise, lead to an increase in the interest rates. In these cases, the Central Banks talk about “the monetary policy tightening,” and the tone of comments is described as “hawkish”. Accordingly, the quotes rise (the national currency becomes more expensive and less attractive to the investors).
The exception is a sharp inflation growth amid a weakening economy: situation, in which the Central Bank can ignore a surge in prices in the expectation that an overall slowdown will cause a suspension in the upward trend.
Lower inflation increases the chances of lowering rates in the future. Then, in the world analytical reviews, the phrases about the “softening of the policy/rhetoric of the Central Bank representatives” and about “their dovish comments” will begin to appear. In this situation, the national currency rate, on the contrary, falls. Without an increase in the interest rates or with the prospects for their reduction, a lot of “cheap money” appears on the market, which encourages commercial banks to provide loans to individuals and businesses.
Traders pay attention to the dynamics of the previous period (m/m, q/q) and the inflation rate to the same period a year earlier (y/y). Central Banks use pivotal (baseline) inflation figures for the same period a year earlier, cutting off volatile changes in the prices of energy, food, and sometimes taxes. After they are made public, traders immediately begin to react to how much the data differ from expectations, and the exchange rate of the national currency is experiencing strong fluctuations.
If the published data is strikingly different from the predicted by the global agencies, traders act with lightning speed. The stronger the actual value differs from the forecast, the more violent the reaction will be: let's say, a wave of position closure will follow, or vice versa, a massive opening of deals in an obvious direction.
Important to keep in mind that trading is a game of expectations. For example, traders always expect the central bank to change the interest rate, following an increase/decrease in inflation.
Be sure to pay attention to the interconnection between the inflation rates and oil prices.
When a few years ago Brent fell from $100 to $30 it caused a shock on the financial markets. Although with a lag of a couple of months, inflation has dropped significantly around the world, and key central banks have noticeably changed policy for several weeks: from the willingness to raise rates, to a pause in their increase or new programs to support markets.
All this was done to ensure that the economies of the largest countries were not covered by deflation, which could later develop into an economiс depression. At the same time, you should not think about raising inflation as something negative. Expecting that prices will not rise, buyers are in no hurry to open deals to buy. The excessive depreciation of goods leads to a financial deficit, the lack of the necessary amount of funds in the economy and holes in the national budget. It turns out that there is no money in the country not only for development but also for covering vital expenses.
You should also know how countries are used to get out of this situation. Among the main tools:
In the case of historical oil prices fall, such the expedients had worked. Ultimately, inflation occupied normal levels, and the Fed was able to return to the rates raising (at least, began to actually talk about it in 2019).
The EU inflation has also begun to grow in 2017, but in this regard, the ECB fell behind the Fed in time. For almost the entire year, the euro has been rising in pairs with all major currencies just because trading is a game of expectations, and bidders have already been tuned to the “normalization process” by the ECB.
CPI interpretation
The EU and the US Consumer Price Index is important for the entire foreign exchange market.
In total, the central banks of these two countries represent the largest economies in the world as well as the main currencies, USD and EUR, competing with each other. Consequently, their actions dictate a common monetary policy on Forex.
Core CPI (Base Consumer Price Index) is “cleared”, i.e. its value does not take into account changes in the prices of energies, food, and car sales since all that data is too changeable and distort the statistics.
We recommend tracking the Basic CPI data since it is the main instrument of the ECB and the Fed to measure inflation (hence, it influences the USD and EUR quotes changes).