Consumer Price Index, in short, known as CPI, is one of the most closely watched Fundamental Indicators. It is the most direct measure of the current inflation in the economy that a citizen can look at and find out. Hence, Understanding the Consumer Price Index, its history, and the resultant effect it has on the market is very important to build an understanding of the macroeconomics of a nation.
What is the Consumer Price Index?
As the name suggests, the calculation of this index is from the viewpoint of the end consumer, i.e., a regular citizen who buys his/her daily needs from a local grocery store or market. Consumer Price Index, in the simplest sense, is the average of the most commonly purchased household goods and services like toothpaste, milk, grocery, petrol, etc. But instead of a simple average here, each good and service is assigned a certain weightage based on their importance or usage degree amongst the population.
For example, milk, which is a daily need for many consumers, will have a higher weightage in the mean price calculation than that of furniture, which we do not purchase daily or frequently. Also, when we say most commonly purchased goods and services, it covers a wide range of goods and services (over 80,000 items) and does not include rarely purchased items like stocks, bonds, foreign investments, or real estate.
How is the Consumer Price Index CPI calculated?
The Bureau of Labor Statistics (BLS) surveys the prices of 80,000 consumer items to create the index and publishes it monthly. The Consumer Price Index has two subcategories; one is CPI-W, which stands for Consumer Price Index for Urban Wage Earners and Clerical Workers. CPI-W statistics are published first, and later the CPI-U (Consumer Price Index for Urban Consumers) values are released. CPI-U is a broader statistic in terms of population and goods & services coverage.
CPI-U is the more accurate and complete statistic relatively as it takes the urban population, which represents about 93% of the United States population into account. While the CPI-W covers only about 29% of the population. Hence, It is the measure of an aggregate weighed in the price level of most commonly bought goods and services. The list includes items like food, clothing, shelter, fuel, transportation fares, service fees (water and sewer service), etc.
Consumer Price Index, whenever released, is given out as a percentage change, and here the change is concerning the previous number, which can be monthly, quarterly, or yearly.
Note: Here, the base year cost amounts to 100, and this base year is in the year 1982 to 1984, where the average amounted to 100. But the data released monthly is shown as a percentage increase or decrease concerning the previous period (usually the previous month).
Why is the Consumer Price Index important?
The importance of the Consumer Price Index is many-fold. First are the range and history of the data. With such a huge data set, the reliability is pretty high, and it usually depicts the macroeconomic picture of a country. For example, the history of CPIAUCSL (Consumer Price Index for All Urban Consumers: All Items in U.S. City Average) goes all the way back to 1947. Second is the frequency & direct ground-level nature of the statistic meaning this data brings out. CPI is a real-time reflection of the current economic situation faced by the end customer or citizens.
Thirdly, the change in CPI is useful to ascertain the retail-price changes associated with the country’s cost of living. Hence it is used widely to assess inflation in the United States. In this Index, there are many subcategories, wherein certain goods and services get included or excluded from the basket to give a more accurate picture of inflation in absolute or relative terms. For example, Core CPI strips away food, gas, and oil prices from the equation as the prices of these items are relatively volatile.
How can the Consumer Price Index be Used for Analysis?
Due to the diversity in the statistics, different sectors of economists can isolate and use the Consumer Price Index for their purpose. For example, the United States Bureau Of Labor Statistics provides indexes based on various geographic areas also. Moreover, they even release average price data for select utility, automotive fuel, and food items, which gives this Index the status of a key indicator in gauging multiple economic indicators.
Consumer Price Index is a widely used indicator for inflation measure. For other economic indicators like hourly wages and currency worth within the nation (dollar’s purchasing capacity to procure goods and services), CPI can be considered as a regulator. On average, for a developed nation like the United States, 0.2-0.5% of Consumer Price Index increase is common, and any number beyond these figures usually indicates volatility in the growth of the economy in either direction.
Sources of Consumer Price Index
The U.S. Bureau of Labor Statistics releases all the indexes that are mentioned above. This data can be found here – Consumer Price Index
You can also find the same indexes along with many others with a comprehensive summary and statistics on the St. Louis Fed website as given below.
CPIAUCSL (CPI for All Urban Consumers: All items in U.S. City Average)
This is a broadly used statistic for measuring the overall inflation. It includes Food and Energy prices, unlike CPIFESL. The information related to this index can be found here.
CPIFESL (CPI for All Urban Consumers: All items minus the Food and Energy in U.S. City)
It excludes volatile components like Food and Energy (Oil Prices) and gives more of a Core CPI change within the United States. The information related to this index can be found here.
Impact due to news release
In this section of the article, we will analyze the impact of the Consumer Price Index (CPI) on a currency right when the announcement is being made and see where the market finally gets to. The image below shows that the CPI data has a huge impact (Red box indicates high impact) on the currency, which means it might cause a drastic change in the volatility after the news announcement. Ideally, if the actual CPI numbers are greater than the forecasted numbers, it is good for the currency and vice versa.
We have taken the recent CPI data of Australia, which is quarter-on-quarter. The quarterly data is more important and impactful than the monthly numbers. The below image gives the 4th quarter data of CPI that was measured in January, and the next quarter data will be released in April. We see below that the CPI data for the 4th quarter was 0.7%, which is 0.2% greater than the previous reading. It is also 0.1% greater than the forecasted number. But, let us see how the market reacted to the data.
AUD/USD | Before The Announcement
The above image represents the chart of AUD/USD, where we see that the market is in an uptrend showing the strength of the Australian dollar. One of the reasons behind the uptrend is that traders and investors forecast the CPI data where they are expecting a 0.1% increase in the same. If the CPI numbers are increased more than expected by the ‘Australian Bureau of Statistics,’ it could be the best-case scenario for going ‘long’ in the market. However, if the numbers are below expectations, volatility could increase on the downside.
AUD/USD | After The Announcement
Here, we see a sudden surge in volatility on the upside that after the news announcement is made. The reason for this is that the CPI got increased by 0.2%, where the market was expecting a 0.1% rise. The large green candle shows how impactful the CPI data is on the currency. From a trading point of view, one should not be chasing the market but instead, wait for a pullback at the nearest support and resistance area and then take suitable positions. The CPI data was so positive for the Australian dollar that the price does not even come below the moving average. ‘Take Profit’ for the trade can be at the new ‘high’ with a stop-loss below the opening of the news candle.
AUD/CAD | Before The Announcement
AUD/CAD | After The Announcement
The AUD/CAD currency pair appears to be in a ‘range’ just before the news announcement and is at the bottom of the range. An interesting way of positioning ourselves in the pair is by having small ‘buy’ positions before the news announcement. Because the forecasted CPI data is greater than the previous reading, and we are at a technically important level that is supporting our ‘buy’ positions. The news outcome makes the ‘support’ area work beautifully as the market shoots up to the resistance area. Here too, the data proved to be very positive for the Australian dollar as a higher CPI data drives the currency higher. We can hold on to our trades even if the price is at ‘resistance’ since the news data is very good for the currency, and it has the potential to break the ‘resistance’ and move further.
EUR/AUD | Before The Announcement
EUR/AUD | After The Announcement
In this currency pair, the Australian dollar is on the right-hand side, which means a positive CPI data should take the currency lower. We can see that the Australian dollar already strong as the market is in a downtrend, and the market participants are optimistic about the CPI data of Australia. After the CPI announcement, the volatility increases on the downside, taking the price to a new ‘low.’ Again, when we witness better than expected data of any economic indicator, we should not be chasing the market but wait for a retracement to key levels. In this case, since we don’t see a retracement after the red ‘news candle,’ only aggressive traders can take ‘short’ positions with the confidence that the CPI numbers were exceedingly better than before and that it will take the currency lower.
That’s about CPI and its impact on the Forex market. We hope you find this information useful and if you have any questions, shoot them in the comments below. Cheers.