Complete Guide to Interest Rates and CPI
The previous article here on the Forex Trading Academy dealt with the central banks’ meetings, and the corresponding dates to watch on the economic calendar. Those dates are vital for keeping 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: specifically, what the central bank is doing with 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 fuss is about!
Central Banks’ Mandates
Every central bank in the world has a mandate, which is to explain the reason for moving on interest rates. As a rule of thumb, inflation is the main thing any central bank is constantly watching. Inflation takes various forms, and there are different figures around the world that are being watched; but, more or less, it comes down to the same thing: the Consumer Price Index (CPI). Inflation represents either the whole, or part of, a central bank’s mandate. Most of the time, inflation control is the sole 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, such as the Federal Reserve (Fed) in the United States. There is more on this to come a bit later in this article.
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Inflation is part of every central bank’s mandate. No matter what 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 converse is valid as well: If inflation is moving to the downside, or falling, the central bank will react by easing the monetary policy, or cutting the rates. There is therefore a strong, direct correlation between inflation and interest rates, and this is what makes the CPI so important. There are, however, multiple types of CPI to watch for. For example, in the United States, the Fed’s favourite inflation measure is the Core CPI. This indicator does not consider changes in transportation, food and energy prices. It is believed that it is only when core inflation is picking up that the economy is truly affected and the FED is going to start raising rates (or cutting them if the core value is falling). The European Central Bank (ECB), for example, has inflation as the only part of its mandate. This means that the central bank will move on rates based on how inflation is moving.
CPI releases all over the world are therefore crucial to the value of a currency, and for building expectations regarding its next moves. What traders do is look for clues regarding what the central bank is going to do next time it decides 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 pair on the Forex market) after the inflation figures are released, on the expectation that the central bank will move on rates the next time it holds a meeting.
Still related to the overall inflationary phenomenon and its importance, the Producers Price Index (PPI) is closely watched as well. This PPI is considered to be a lagging indicator, and in many ways it is. It reflects the inflation figures on the producers’ side, and it takes a while until these changes are seen on the consumer side. This is why it is a lagging indicator, but keep in mind that in the end the producers’ inflation will be passed on to the consumers, and the central banks will react harshly. It follows that the earlier that traders are aware of the possible changes in overall inflation, the better. Buying or selling, or adjusting the account accordingly, is mandatory when inflation figures are released. As you can probably see as the big picture by now, inflation is the cause of central banks moving on interest rates, and interest rates are the main cause for currencies moving. The overall Forex market is affected by the level at which 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 decisions 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 does not only look at inflation figures, but also at employment data. Unemployment rate and overall jobs data are part of the Fed’s mandate, and this means that markets will move aggressively when this data is released in the United States.
More about the US employment data and its importance to come in the next article, but for now keep in mind that balancing two important economic data sets, such as inflation and jobs numbers, 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 that the Fed’s mandate is more complex than it is in other regions in the world, even though this should be taken with a grain of salt. This is because any central bank considers ALL of the factors that influence an economy, not only the one/ones that are part of its mandate. After all, the “job” of a central bank is to make sure the economy is growing and to 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.