Inflation and CPI

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. As price levels rise, each unit of the underlying currency buys fewer goods and services. This effectively erodes the level of purchasing power over time and the underlying value of the currency.

A level of inflation in the economy is desirable however, as it is indicative of underlying economic growth and expansion. Central Banks will seek to keep inflation in check by controlling monetary flow in the economy by the use of interest rates. Therefore understanding where inflation is heading is a precursor of understanding the likely direction of interest rates and economic growth cycles.

Deflation is the opposite of inflation. In a deflationary environment prices contract. This suggests that demand in the economy is slowing. In a deflationary environment the consumer will often delay making purchases, with the view that the longer the delay, the cheaper prices will become.

Inflation figures are vitally important to the Forex markets. If inflation figures come in higher than expected, traders will view an increase in interest rates as more likely in the near future. If the figures fall short of expectations then this is likely to indicate that a rate change may be some way off.

The two central barometers of inflation are the Consumer Price Index (CPI) and the Producers Price Index (PPI). The CPI measures inflation at the retail level, while the PPI (Producer’s Price Index) measures the inflation at the wholesale level (producers). Figures are released monthly in the United States, Europe, the United Kingdom, Canada and Japan. Elsewhere this data tends to be released to the markets quarterly.

Consumer Price Index

The CPI the most watched of the fundamental releases as it provides a good indication of the state of inflation within the economy and ultimately the likely direction of interest rates.

The Consumer Price Index measures the average change over time of the price paid by consumers for a ‘basket’ of goods and services in the economy. The index shows how price increases effect typical household spending or purchasing power. The index is benchmarked at 100 with a higher figure indicating an increase in prices over time and lower figure indicating a decrease in prices over time. For example an index reading of 105 would indicate that there has been a 5% increase in prices since the reference period. A reading of 95 would indicate a 5% decrease in prices paid since the reference period.

This percentage change since the previous reading is referred to as the ‘rate of inflation’. This figure is quoted either monthly or annually. For example, an annual rate of inflation of 3% would mean that the same basket of goods purchased for £100 would cost now cost £103 (3% more) now than they had 12 months ago.

The consumer price index measures price changes at the retail level. It registers the price fluctuations only to the extent that a retailer is able pass them on to the consumer. Thus, in an environment of high competition and falling or low demand growth, the retailer may have to cut on his profits, and a rise in PPI may not be reflected in the price the consumer pays, as measured by the CPI.

Producer Price Index

While the Consumer Price Index monitors the effect of inflation on consumer products, the Producer Price Index (PPI) measures changes in the prices charged by wholesalers to their clients such as retailers. Therefore the index includes both commodities and materials making it responsive to changes in their pricing and also manufacturing and industrial trends.

The PPI figure is important as the producer is at the beginning of the economic supply chain. Therefore an increase in prices at this stage of the economic cycle can prove to be an early signal for predicting price changes further up the chain for the consumer. However at times in the economic cycle (downturns, periods of increased competition) a rise in PPI readings may not be reflected in CPI readings. This is because retailers may actually absorb some of this increase and not pass it on to consumers in order to maintain competitive. Therefore it is useful only in giving a sense of the underlying price developments. However this is not always reflected in the consumer’s bills (as measured by the CPI)

The key point to note here is that higher CPI readings (and to a lesser extent PPI readings) are likely to push Central banks to increase interest rates as a means of capping inflation. By increasing the interest rate the yield of the currency increases and in turn will see the currency appreciate against its peers.

Conversely falling inflationary readings are likely to see the Central Bank lower interest rates to stimulate economic growth, resulting in a lower yielding and therefore depreciating currency.

Next: Employment Figures and Non-Farm Payrolls