Consumer price index (CPI) is a measure that examines the weighted average of changes in prices of consumer goods and services bought by each household in a determined period of time.
A basket of consumer goods and services tracked from month to month such as transport, food, medical care, education, housing and recreation excluding taxes are used by taking their price changes for each item and then take their averages.
Changes in the CPI is then used to assess price changes associated with the cost of living.
The CPI is measured using two indexes:
The CPI-U which measures CPI for urban consumers and the CPI-W which measures CPI for urban wage earners and clerical workers.
CPI is one of the most important indicators that investors, government and analysts can rely on to gauge the level of inflation in consumer goods.
How does CPI affect the Country’s economy
Like we have seen before, CPI is a major indicator used to evaluate the level of inflation in consumer goods. Therefore changes in the CPI can have a great effect on the economy.
When the CPI of a country continues to increase, consumers are discouraged to save and their purchasing power falls. This is a sign of inflation and may result to a fall in the value of currency caused by inflation. As a result the interest rates are likely to be increased by the central banks to fight the inflation pressure and making borrowing expensive and back up the currency value.
On the other hand, a fall in CPI discourage consumers from spending especially buying luxury goods / non-essential items. Because they expect prices to continue falling they tend to save money by waiting for prices to be cheaper. Lower consumer spending may lead to lower economic growth hence more deflationary pressure in the economy. As a result of economic slowdown in the country,the central bank reacts by cutting interest rates to encourage borrowing for investments and expenditure.
How CPI affects the Forex market.
Traders use the changes in the CPI data released to assess the strength of currency in the forex market. Changes in the CPI are used to determine the levels of inflation which also influences the decisions taken on the interest rate therefore becomes the major determinant of the value of currency.
When the CPI or Core CPI comes out higher than expected, the currency increases in value relative to other currencies and the forex market becomes more bullish.
When the CPI or Core CPI comes out less than expected, the currency tends to reduce the value of the currency relative to other currencies.
Traders mostly focus on core CPI data because it excludes more volatile price changes in food and energy commodities.
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