Inflation – Consumer Price Index

Inflation – Consumer Price Index

One of the major economic releases which is followed by investors worldwide, is the Consumer Price Index. After the central bank meetings the inflation figures will be published. Inflation is also called Consumer Price Index or CPI. You can always take a look at the economic calendar to see when the CPI data will be published in the largest economies in the world: the United States, Eurozone, United Kingdom, Australia and Japan.

CPI – Monetary policy indicator

The CPI is a very important indicator because central banks adjust their monetary policy to the inflation level and the standard interpretation is as follows: if inflation is likely to rise, it is said that there are inflationary pressures on the economy and in that case it is expected that the central bank will subsequently increase interest rates in order to prevent inflation. The outcome will be that the local currency will appreciate if the central bank raises its interest rates, since everyone wants to possess a currency which yields higher rates.

The opposite is also true: if the outcome of the CPI is lower than expected and well below the target of the central bank, the market will prepare for a reduction in interest rates by the central bank for the next time they meet. A reduction in interest rates is always a bad sign for a currency. In the case of binary options we would have to buy call options if the actual CPI exceeds forecasts.

CPI data makes currencies move

If the CPI data comes out below expectations this is seen as negative for a currency. Therefore, in these cases we go short or we buy put options in the case of binary option trading. Central banks have a mandate the purpose of which is to keep inflation below or around 2%. This means that inflation levels higher than 2% are not desirable, because money loses its value. At the same time, lower inflation levels are also seen as a threat. If inflation falls below 0% we talk about deflation or about negative inflation.

Inflation or CPI data is published on a monthly basis and has some variations with respect to the way it is calculated from country to country. To give you an idea, in the United States, the Federal Reserve looks to “core inflation” and not to the general CPI. “Core inflation” means that the prices of oil and energy are not included in the calculation, since they have the characteristics of being very volatile and cyclical.

What impact does monetary policy have on the stock market?

When investors interpret inflation figures they try to get an idea of what central bankers are going to do the next time they meet. In October 2013 for example, the CPI in Europe stood at 0.6% while expectations were 1.1% resulting in a decline of the Euro against a number of other currencies. The reason for that was that two weeks later the ECB (European Central Bank) would hold a meeting and expectations were that it was going to lower the interest rates. It indeed turned out that they actually lowered the interest rates and the market fell by more than 100 points.

What I am trying to explain here is that a single position or binary option based solely on a CPI release can yield a lot. It is a widely known fact that when interest rates are discussed, the market moves violently. In the example above, after the weaker than expected CPI, one could have bought put options with an expiration time of one month (or a long position in case of Forex trading) and one would have made huge profits.

Trading CPI news

Trading the news nowadays is a little trickier because financial markets are largely affected through algorithmic trading. This makes it difficult to predict the correct direction of a stock, commodity or currency pair, though certainly not impossible. The way to successfully trade the news is to wait until the data has been published and then trade based on the actual figures compared to expectations. If the actual figure is higher than expected, say Australia’s CPI, then it is likely that the central bank will raise interest rates next meeting.

Suppose that in this case we would like to trade binary options on Australian Dollar denominated financial product, say AUD / USD, then buying call options would be the cleverest thing to do. To set the right expiration time, one should look at the economic calendar to see when the next interest rate meeting is held. The call option must be active and the expiration date must be set after this date to guarantee a very high probability of a successful trade.

Continue reading: Lesson 8: Central banks and monetary policy