Forex Fundamental Analysis: How to Trade with the CPI / Inflation Reports!

[00:00:00] Speaker 1: In today's video, we are going to be discussing a key influencer in the currency market, the Consumer Price Index, or CPI for short. The Consumer Price Index is a key tool for central banks when making monetary policy decisions and is also an important tool for us as traders studying the fundamental story of the forex market in order to make more informed trading decisions. The goal of today's video is to define what exactly this key economic tool is, and then we're going to discuss some ways that we could possibly implement the CPI into our currency trading strategies. Before we get started, though, if you want more free content about trading forex, make sure to subscribe down below. Otherwise, your account is 69 times more likely to blow in the next 420 hours. With that said, let's get started. So basically, the goal with CPI numbers is to attempt to measure inflation in a particular economy. Now, all of the major currencies that you know, things like the Australian dollar, the New Zealand dollar, the US dollar, the euro, they all report the inflationary numbers in their economy. And this is, like I said, an attempt to try and combat a economy that is growing too fast or an economy that is slowing down. So we're going to talk more about how that works as we go along, but stay tuned. The way they do this is by using, basically, a basket. Think literally a basket that you might get on Easter or a basket of goodies you might bring to a new neighbor, something like that. More specifically, though, in this case, we're going to be using a market basket. Now, according to the US Bureau of Labor Statistics, the Consumer Price Index is a measure of the average change over time in the prices paid by ermid consumers for a market basket of goods or services. Now, we need to know what exactly a market basket is. So this is kind of what it means. A market basket is a fixed set of goods and services whose prices are used to calculate the changes over time. So if we set up a basket, we are going to check how those same products might cost year over year. And if they are rising, we might see some sort of inflation. And if we see prices lowering, it could mean the opposite. And this is key economic data for central banks. The goal here is to measure and evaluate how that same basket of goods changes year over year, month over month, however much time we want to measure. For example, if the price of a bottle of Coke, a watch and a pack of gum cost me $2 20 years ago, but it would now cost me $8, we could arguably attribute some of that change to inflation of the US dollar. Now, stay tuned. We're going to talk about some pros and cons and how we can actually use this to trade. But we need to understand these concepts before we keep going. The cool part about this is we can actually implement these concepts into our analysis and make better informed trades in the currency markets because of this economic trend that we could observe. It's kind of crazy. Okay, so what we can do to visualize CPI is we can use a simple table. No wrong table. There we go. Okay, so we need a base year, which we can make the year 2000 in this case, and we'll do a measurement each five years measuring the cost of our theoretical market basket. Now to calculate the CPI value, we'll need to do some simple math. Don't worry, it's nothing crazy computing the distance from the sun plus the radius of the moon divided by the number of losing traders. And voila. Nah, just kidding. It's actually really simple. And in fact, you don't even need to do this math. Usually it is done for you on places like forexfactory.com. You can pull up their calendar and you can see the CPI numbers being printed on a regular basis. I believe in most places I know in the US, we report them once a month. Usually it's around the middle of the month. Okay, so the actual equation is we just divide the market basket current by the market basket base, then times it by 100. Now that we have this number, we can get to the big conclusions, which is measuring inflation rate. Inflation rate uses the following formula. I won't bore you, but it is pretty simple. CPI new minus CPI comparison year divided by CPI comparison year times 100%. And remember, you don't actually have to remember these sort of equations. But for those of you guys who want to know them, this is basically what they are. Now we need to talk about what this tells us and how this can actually be used for our trading. Again, I wanted you guys to have a general understanding of what the CPI is. The consumer price index needs a definition first. Now we can talk about a little bit of what we can use it for in our trading. So now that we have an understanding for what it is, and a general idea of how it's calculated, how can we actually use it? This is the fun part. Price stability is the primary goal of central banks. You should know that when we're talking about they make the policies, their goal is to keep things smooth and to stick to a steady and healthy rate of growth over time. They don't want things to be massively inflating very quickly or deflating very quickly. An increase in CPI is considered inflation and a decrease in CPI is considered disinflation, deflation. I've heard it said a couple different times, but basically it is saying the value of that dollar is either gaining or decreasing to buy that market basket. So a rise in consumer prices of our market basket shows a period of inflation as the buying power of the consumer decreases, right? So if the market basket is going up, it means that the underlying currency that you're buying it with is decreasing in value. Okay. Now, conversely, a drop in consumer prices of our market basket shows a period of deflation since the buying power of the consumer is actually increasing. Now you might say, oh, well, that's great. My, my U S dollar or my great British pound or my euro, it goes further for me, but that is actually kind of a concern for central banks. Let's break it down. When consumer prices rise, a central bank may elect to raise interest rates to keep the inflation contained. So this is actually considered bullish, right? So when your dollar is going down in value, or at least your buying power is decreasing, this is actually considered bullish for the underlying economy. Since raising interest rates can attract investors and show an overall healthy economy. Remember the banks set interest rates and interest rates, investors attract investors from around the world to buy in and invest in a currency. So if prices are rising, it could actually mean that the economy is active and consumers are actively bidding up prices of goods. This is a good thing. It shows strength in an economy in some cases. So conversely though, when consumer prices fall, as indicated again by that CPI, a central bank may elect to lower interest rates to stimulate a potentially slowed economy. This is considered bearish for the currency as investors may exit their investments in the underlying currency in favor of higher yielding interest rates elsewhere, right? So a bank, a central bank, maybe they see that the economy is slowing because people are holding on to their money and they're not moving it around as much. And they may say, okay, we need to, uh, we need to cut interest rates so that people are less willing to hold on to their money because it collects less interest. And instead we'll put that money out into the economy. They'll invest in things and they'll push back into the, to the system, right? That is kind of the general high level idea of, uh, basically cutting interest rates. Again, our goal here is to use the CPI to try and, uh, get a, an idea of what central banks may choose to do next. If we know that interest rates are likely to be cut in the future, that could be actually pretty, uh, interesting for the future price movements. If we know they're going to cut, that might be bearish for the underlying currency that we are looking at, because if you're collecting 2% per year on your us dollar, and then they cut it down to 1%, it's much less appetizing to investors. So people will probably sell their us dollars in exchange for higher yielding currencies elsewhere. So as a recap, we know that by looking at the CPI numbers, we can know if an economy is healthy or unhealthy based on the buying power a currency has on a fixed basket of products and services. Now I should say, this is not the only indicator and it's not the only way to tell if an economy is healthy or unhealthy, but it is a component and a valuable tool to gauging the economy that we are talking about. An increase or decrease in buying power affects the evaluation of a currency because of the potential interest rate changes it could lead to. An interest rate hike may occur to slow down inflation in a strong economy, which is considered bullish for the currency evaluation, because if the bank is basically saying, hey, we need to slow down this economy, it's showing how strong the economy really is. But the bank doesn't want the economy to melt to the upside, right? We want things to happen at a consistent and steady rate, not an unhealthy speed. Conversely, an interest rate cut may occur due to poor CPI numbers in order to stimulate a slow economy where prices of the fixed market basket are falling. Okay, so now we need to talk about some of the drawbacks because the CPI number is not the only measurement like I've hinted at throughout this video. So there are some drawbacks that we need to discuss now. The first one is that the CPI represents the typical household, which doesn't necessarily represent every household. Remember, we're talking about a market basket of goods that not everybody buys, but is considered a general something people buy, right? But the hard part about that is that the typical household does not necessarily represent every household out there. And so this number is still helpful, but not perfect. Another possible problem is that because of the competition of businesses to reduce prices to stay competitive, especially in capitalist USA, this can skew the numbers a bit. Going back to our Coke product example from before, matter of fact, actually let's make it a diet Coke. If Coca-Cola finds a better way to mass produce their product, it could cut the cost a bit, which is not necessarily due to inflation. Hopefully you can see how that could potentially make the numbers a little bit weird. So it's not perfect, but it's still a great tool that economists and market analysts use to regularly try and predict future trends in an economy. If you want more videos like this in the future, make sure to subscribe to my channel down below and turn post notifications on so you don't miss any future updates. On your screen, you should see some more uploads about to pop up and I recommend you check them out for free. Thank you so much for watching and we'll see you back next time.