Interest Rates and CPI (Consumer Price Index)
The previous article here on the Forex Trading Academy dealt with the central banks meetings and what are the dates to watch on the economic calendar. Those dates are vital for being up to date with what the monetary policy in a specific jurisdiction is looking like. As mentioned in that article, what matters the most is what the central bank’s monetary policy is, namely, what the central bank is doing with the interest rates. This is where the focus should be: the interest rate of a currency. Everyone wants to own a currency that pays a big interest rate, or at least a bigger interest rate when compared with other currencies. This is what all the fuzz is about!
Central Banks Mandate
Every central bank in the world has a mandate. That is, what is the reason for moving on the interest rates. As a rule of thumb, inflation is the main thing a central bank is watching. Inflation has various forms and there are different numbers around the world that are being watched, but, more or less, it is the same thing: Consumer Price Index (CPI). Inflation is representing either the whole mandate or part of a central bank’s mandate. Most of the times, inflation is the only mandate of a central bank and the normal target is to keep inflation below or close to 2%. However, there are central banks in the world that have other things to consider before moving on rates, like the Federal Reserve in the United States (FED). More on this to come a bit later in this article.
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Inflation is being part of every central bank’s mandate. No matter the jurisdiction or part of the world, central banks are watching inflation with a close eye. The norm is that if inflation is picking up, the central bank is going to hike the rates. Hiking means raising the rates. The other way is valid as well: if inflation is moving to the downside, or falling, the central bank will react with easing the monetary policy or cutting the rates. Therefore, there is a strong, direct correlation between inflation and interest rates and this is what makes the CPI so important. There are multiple types of CPI to watch for, though. For example, in the United States, the FED favorite inflation measure is the so-called Core CPI. This indicator is not considering changes in transportation, food and energy prices. It is believed that only when the core inflation is picking up, the economy is truly affected and the FED is going to start raising rates. Or cut them, if the core value is falling! The European Central Bank (ECB), for example, is having inflation as the only part of its mandate. This means that the central bank will move on rates based on how inflation is moving. Therefore, the CPI releases all over the world are crucial to the value of a currency and for building expectations regarding its next moves. What traders do is to look for clues regarding what the central bank is going to do next time it is deciding on the interest rates and inflation is the first thing on the list. Consequently, traders are positioning for a central bank’s interest rate decision well in advance, by buying or selling that respective currency. Often traders will buy/sell a currency (currency pairs on the Forex market) after the inflation figures are released on the expectations that the central bank will move on rates next time it holds a meeting. Still related to the overall inflationary phenomena and its importance, the Producers Price Index (PPI) is closely watched as well. This PPI is being considered as a lagging indicator, and, in many ways, it is. It is reflecting the inflation numbers at the producers’ side, and it is taking a while until these changes will be seen on the consumer side. This is why it is a lagging indicator, but keep in mind that in the end the producer’s inflation will be passed on to the consumers and the central banks will react hardly. Therefore, the earlier traders are aware of the possible changes in the overall inflation, the better. Buying or selling, or adjusting the account accordingly, is mandatory when inflation numbers are released. As you probably got the picture by know, inflation is the cause for central banks moving on interest rates and interest rates are the main cause for currencies to move. The overall Forex market is affected by the level an interest rate is set and this, in turn, is dependent on the inflation figures.
While inflation is key to any central bank’s interest rate decision and monetary policy, in one case, it is not enough. We’re talking here about the most influential central bank in the world: the FED. As it turns out, the FED is not only looking at the inflation figures but also at the jobs data. Unemployment rate and overall jobs data are part of the FED’s mandate and this means markets will move aggressively when this data is released in the United States. More about the US jobs data and its importance to come in the next article, but for now keep in mind that balancing two important economic data, like inflation and jobs numbers are, is not an easy task. It may happen that sometimes inflation is shooting up but job creation is lagging, or the other way around. This means the FED’s mandate is more complex than the one in other regions in the world, even though this should be taken with a grain of salt. This is because a central bank is considering ALL the factors that are influencing an economy, not only the one/ones that are part of their mandate. After all, the “job” of a central bank is to make sure the economy is growing and adjust its monetary tools accordingly. The next article on our project is dedicated to this jobs data in the United States. This is one of the events that is most watched by traders and high-frequency trading algorithms are crazy about it.
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Recommended further readings
- Economic news, exchange rates and interest rates. Hardouvelis, G. A. (1988). Journal of International Money and Finance, 7(1), 23-35.
- “Short-term interest rates as predictors of inflation: On testing the hypothesis that the real rate of interest is constant.” Nelson, Charles R., and G. William Schwert. The American Economic Review 67, no. 3 (1977): 478-486.