Consumer Price Index

Consumer Price Index

What is CPI (Consumer Price Index)

When we are caught up in the rush of performing our daily tasks and responsibilities, we miss the small details in life. One of these major details is our regular expenses like housing, transportation, and food. Although we often don’t account for our everyday spending, it is the largest item which drains our livelihood. When the prices in our regular shopping list go up, the amount of free cash in our hand goes down. The increase in prices usually happen in subtle ways, and we are usually unaware of it. This is known as inflation. Basic expenses are mostly the same for everyone, and by monitoring the changes in their prices, we can measure how costly life is getting over time.

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What is the Consumer Price Index (CPI)?

Consumer Price Index (CPI) is the main economic indicator that is used to track the inflation rate and the cost of living in a country.

It comprises a basket of goods and services and calculates the basket price as a weighted average of the constituent items’ retail prices.

CPI is released on a monthly basis, but quarterly and yearly reports are also common. Periodic release of CPI reports allows us to analyse the change in the prices of the individual items as well as the whole basket over time. The rate which the basket price changes over time is also known as the inflation rate.

CPI was first created during World War I when an abnormal surge in prices led to the creation of an index to calculate the cost of living adjustments. In 1984, a baseline of 100 was set for CPI figures in the actual report.

If the CPI figure is 140, it would mean that the inflation is 40% higher than the 1984 figure. Nowadays, CPI serves as the main indicator of inflation and helps the national central bank to adjust its monetary policy in accordance with their inflation targets. A consistent level of inflation (i.e., 2%) is considered healthy for a steady economic growth.

CPI, like any inflation indicators, it is a lagging indicator in the sense that it informs about the change in a past period. When a country publishes a CPI report, the results are expressed as the percentage of change compared to the previous issue.

If the result is positive, the consumer prices have increased, and the inflation rate is rising. In the opposite scenario, the consumers would be paying less, and inflation would be decreasing. The reaction of markets would depend on the economic conditions of the country.

For example, under normal economic conditions, an increasing CPI would encourage the central bank to raise interest rates, which would add value to the currency and attract traders to buy more.

However, if the current inflation is too high or the economy is in recession, the stagnant income level of citizens wouldn’t match the rising cost of living and eventually reduce consumer spending over time. Thus, it can create the opposite effect and repel investors away.

How to Calculate the Consumer Price Index?

Consumer Price Index measures the inflation rate of the consumer prices in an economy by creating a basket of basic goods and services. Generally, CPI baskets include 80 sub-indices from 8 categories, ranging from food and clothing to housing and transportation. Methodologies to comprise the basket and formulas to calculate price indices can differ slightly in each country and region.

There are three different CPI formulas to calculate the price index: Laspeyres, Paasche and Fischer. In the formulas below, the legend is as follows:

  • p: price of an item
  • q: quantity of an item
  • c: current time period
  • b: base time period

Laspeyres Price Index: The items are weighted based on the quantity in the base period.

CPI(L) = Sum of [p(c) x q(b)] for each item / Sum of [p(b) x q(b)] for each item 

Paasche Price Index: The items are weighted based on the quantity in the current period.

CPI(P) = Sum of [p(c) x q(c)] for each item / Sum of [p(b) x q(c)] for each item 

Fischer Price Index:Calculates the geometric mean of Laspeyres and Paasche.

CPI(F) = √ [CPI(L) x CPI(P)]

Each CPI calculation gives us the ratio between the basket prices of the current period and the base period. The ratio is then multiplied by 100 to express the change in percentages.

How to Calculate the Inflation Rate from CPI?

Because the inflation rate is measured as the percentage change of a price index (inflation definition), the value of the CPI is closely monitored. The inflation rate formula is as follow:

Inflation Rate = [CPI(c) – CPI(b)] / CPI(b)

For the financial markets, the inflation rate indicates the path for future interest rate changes, with immediate implications on current prices. For example, if the CPI deviates abruptly from the central bank’s target, the markets would expect the central bank to step up and raise or cut the interest rate level. This expectation would lead the investors to either buy or sell the currency significantly more.

How to Trade with the CPI Data Releases?

As the main economic indicator of inflation, Consumer Price Index plays an important role in a central bank’s monetary policy decisions. The central bank of each country is responsible of creating a monetary policy to facilitate economic health and growth.

Along with GDP and unemployment rate, inflation is an important aspect of economic growth and the inflation target is usually set between 2% and 3%. Using interest rates as a tool, the central bank can manipulate and control the inflation rate.

Interest rate decisions always top the list of most influential economic events and have a powerful impact on the value of the national currency. Since central banks decide on raising or cutting the interest rates based on the performance of the inflation rate, CPI reports are followed closely by investors and analysts and strongly influence the market sentiment towards the currency.

The release of CPI report is usually bound to create large-scale volatility in the financial markets, especially in the Forex currency pairs.

There are two ways to look at the CPI release. One is to compare the actual release with the forecast and the previous release. Another is to interpret it according to the central bank’s target. In either case, the outcome triggers volatility and leads to numerous short-term opportunities for news trading strategies.

Let’s assume that the U.S. is expected to publish a monthly CPI report. The forecast is 1.3% and the previous result was 1.1% – so, the analysts are anticipating CPI to rise.

When the report is released, the actual outcome is 1.5% and beats the forecasts positively. The expectations for the U.S. Federal Reserve to raise interest rates would build-up, and the traders would tend to buy USD.

As a result, currency pairs like EUR/USD and USD/CAD move in favor of USD, while equities like Apple stocks and NASDAQ 100 index might lose value.

Key CPI Reports Around the World

The CPI report has different names and different weights in countries around the world (inflation rate formula changes for developed and emerging economies). Some of them are Laspeyres indexes, some Fisher indexes– but they all have a strong impact on the financial markets.

USA

The U.S. CPI covers only the urban area – hence, it is often called CPI-U. However, the Fed doesn’t focus on the classic CPI because it is a Laspeyres index and suffers from upward biases.

Therefore, in 2000, the Fed switched to the Fischer-based PCE Index (Private Consumption Expenditure) which covers the complete range of consumer spending and not just a basket.

EU

European Central Bank (ECB) collects individually calculated national CPI from each country and combines them into Harmonized Index of Consumer Prices (HICP) using weighted averaging.

  • Region: Europe
  • Date of Release: Monthly and yearly
  • Issuing Agency: Eurostat
  • Affected Assets: EUR; EuroStoxx50; DAX 30, CAC 40; government bonds of EU-members

UK

  • Region: Europe
  • Date of Release: Monthly and yearly
  • Issuing Agency: National Statistics
  • Affected Assets: GBP, EUR; British stocks; FTSE 100; UK Gilts

Canada

  • Region: North America
  • Date of Release: Monthly and yearly
  • Issuing Agency: Statistics Canada
  • Affected Assets: CAD; Canadian stocks; S&P/TSX; Canada Marketable Bonds; Crude Oil

Japan

  • Region: Asia
  • Date of Release: Monthly and yearly
  • Issuing Agency: The Statistics Bureau of Japan
  • Affected Assets: JPY; Japanese stocks; Nikkei 225; Japan government bonds

China

Food weights are higher in the CPI formula for China as a greater proportion of income of the average consumer goes to food.

  • Region: Asia
  • Date of Release: Monthly and yearly
  • Issuing Agency: National Bureau of Statistics
  • Affected Assets: CNY, AUD, NZD; Chinese stocks; Shanghai SE Composite; Chinese Government Bonds

Australia

  • Region: Oceania, Asia
  • Date of Release: Monthly and Yearly
  • Issuing Agency: Australian Bureau of Statistics
  • Affected Assets: AUD, NZD; Australian and New Zealand stocks and bonds; ASX 200 index

Prepare for the CPI Releases with AvaTrade

CPI figures affect the central banks’ decisions on interest rates – therefore, currency prices – directly. Monthly CPI reports are eagerly anticipated as the sudden increase in the trading activity translates into price volatility. All we need to do is to enter AvaTrade’s platform and use the great trading tools to capitalise on the market.

  • When CPI is Released? We can find the date, time, and forecasts for all key CPI releases in AvaTrade’s own economic calendar page.
  • Which Assets to Trade? CPI reports have strong impact on the currency of the issuing country. Thankfully, AvaTrade enables trading Forex currency pairs with high leverage and low spreads.
  • Buy or Sell? We now know that a positive CPI adds value to currency and a negative CPI causes it to lose value. Trading CFDs with AvaTrade, we can benefit from either direction! No restrictions on short selling apply.
  • What About Wrong Predictions? The volatility of CPI means both opportunity and risk; we can use AvaProtect to hedge our positions in case the outcome frustrates the markets.

Markets, opportunities, assets, tools… you are equipped to start trading on Consumer Price Index reports! Whether the prices are rising or falling in our local economy, carefully trading the CPI reports can ensure that your portfolio continues to inflate, without a central bank to control it. Check out when is the next CPI report and ready your positions!

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