HOW THE CONSUMER PRICE INDEX AFFECTS GOLD & USD
When traders are able to comprehend the effect of policy decisions made by Central Banks on the currency markets, they can profitably trade the markets
To be a successful forex trader, it is essential to know the factors behind the demand and supply of currencies. To do this, one needs to first understand Central Banks and how they work — after all, they control the entire world’s money supply.
The Central Bank of any nation has 2 major functions — One controlling inflation and the other is controlling fluctuation in the currency value. To control inflation, you must first be able to measure it and that’s where Consumer Price Index (CPI) comes in.
The Consumer Price Index (also called the Cost of Living Index) calculates the average change in prices of goods and services for a given period and remains one of the most significant economic indicators that have a major influence on financial trading to date. It is usually computed monthly, quarterly or yearly but can be more often. The CPI gives information about consumer-level inflation, one of the central banks' biggest concerns, and further helps to provide data about the overall consumption expenditure.
Calculating the CPI
CPI is computed by taking the average weighted cost of a basket of goods in a given month and dividing it by the weighted cost of the same basket the previous month. It then multiplies this percentage by 100 to get the number for the index.
Effect on US Dollar Index
Brokers like Egmarkets provide the opportunity to trade several currency pairs, including majors, minors, and exotics. However, among the currencies, the major one remains the US Dollar Index.
The CPI has a direct relationship with the Dollar. When the CPI goes down, the value of the Dollar goes down. Similarly, when the CPI rises, the value of the Dollar rises. This is because an increase in the inflation rates causes the Federal Reserve to increase the interest rate, which increases the demand for the US Dollar.
Because of the effect, the CPI has on the Dollar’s performance, forex traders anticipate the release of the CPI figures and the interest rate decisions that the Federal Reserve makes as a result of them.
Effect on Gold
Gold is often seen as an inflation hedge that protects investors against the loss of purchasing power. Gold does not always react to the rises in the CPI and that is because the yellow metal is affected primarily by strong increases in inflation, while moderate increases in inflation or declining inflation do not materially impact the price of gold in either direction.
Nevertheless, the CPI is a useful inflation indicator that provides insights into future Fed actions. The increase in the CPI may also lower real interest rates, which can be positive for the price of gold, and/or spur safe-haven demand for the yellow metal if there is high inflation accompanied by the fear about the current state of the U.S. dollar and the global monetary system. This is why the CPI should be watched closely by gold investors.
How to trade the markets using CPI Data
When data for the CPI is released, forex traders make trading decisions based on the data. The main thing traders look at in the data is the market expectations for inflation and how they will affect the currency’s strength. This information will later determine whether the traders buy or sell currency pairs associated with the particular currency.
There are two ways to examine the market expectations of inflation from the CPI:
- One way is to compare the forecasted figures and the previous figures with the actual release figures. In this way, the traders examine whether the actual CPI release meets the predicted market expectations and whether it has increased or decreased from the previous figure.
- Another way to interpret the CPI is to look at the central bank’s target expectations and use the information to determine whether the interest rates will increase or decrease.
Both of these methods of interpreting CPI provide forex trades with trading opportunities and allow them to try new trading strategies. However, traders should be aware that not every fundamental analysis of the CPI will work out as expected.
In forex trading, broker companies like Egmarkets are equipped with complex instruments and tools that help traders capitalize on the CPI and make profits.
Click here to create a trading account on Egmarkets and start trading.
