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When it comes to Forex trading and trading in general, central banks play the most important role. To be more exact, what central banks are doing with the interest rate is what is moving the market.
Not only the Forex market is affected. Stocks, commodities like gold, oil and silver, bonds, and so on... everything depends on the interest rate level set by the central bank and the monetary policy that is appropriate for the period to come.
Central banks have a mandate, a mission. All of them vow to fight inflation. Any mandate of a central bank that reigns over a capitalistic economy is related to inflation. Only the Federal Reserve in the United States has a dual mandate.
Central banks are setting the monetary policy in such a way to “keep inflation below or close to two percent”. This level is normal for an economy to grow in such a way not to be overheated nor stagnant.
A normal inflationary level is anywhere between 1.8% and 2.2%, but these levels depend very much on the type of the central bank and the favorite measured move to look at it. More details about these to be presented a bit later in the article.
The Fed in the United States is the only central bank to look at jobs creation too. As part of the dual mandate, job creation is an important reason to move on rates.
The CPI or inflation stands for the change in the values of goods and services in an economy. The rule of thumb calls for interest rates to be raised when inflation picks up, and to be cut when inflation is dropping.
Therefore, there is a strong link between inflation and interest rates and Forex trading is highly dependent on them. But not all products are included in the way inflation is calculated.
There is a whole debate in the United States as the algorithm that looks at inflation changed in time. For example, there are goods and services that are not considered at all, while other are extremely volatile.
Fed is looking at the Core number. The Core CPI release is referring to inflation or the change in prices of goods and services in an economy, excluding energy prices, food and transportation.
These are volatile and not to reflect the true state of an economy. As such, traders should look at the change in the Core CPI value, rather than in the headline CPI.
Inflation data is released monthly and the trend can be anticipated based on the factors that influence it. One of the biggest drivers is the oil price.
Just like that, oil-related data becomes important for the Forex traders. The oil-inflation-interest rates cycle makes market volatile.
To give an example, if oil is rising, inflation is rising too, and the other way around. The currency low-inflation environment we’re living in the last years has been accelerated when oil dropped from above $100 dollars to the low $30’s.
In some parts of the world, inflation turned negative. This is called deflation and all central banks can do from an interest rate point of view is to drop the rates to zero.
In some jurisdictions, like Eurozone, Switzerland and European Nordic countries, interest rates were moved into negative territory. It was an unprecedented move that will go down in the monetary policy history books.
Persistent low inflationary levels or deflationary ones (central bankers still like to call deflation as negative inflation!) lead to unconventional monetary policies. Quantitative easing programs (central banks buy their own government’s bonds), TLTRO’s (Targeted Long-Term Refinancing Operations), etc., are examples of such measures that have been taken lately.
Deflation is damaging an economy more than inflation. In a deflationary environment, products are not being bought as consumer spending is postponed.
A vicious circle starts from there on. To put things in perspective, imagine that Japan is fighting deflation for more than two decades now.
Coming back to oil, which drives inflation, which in turn drives interest rates, oil related news is suddenly important for the Forex traders. OPEC (Organization of Petroleum Exporting Countries) meetings, US inventory data, Canadian oil related news... everything matters for inflation and this matters for Forex traders.
The European Central Bank (ECB)’s mandate refers to the headline inflation. However, unofficially, the Core CPI matters for the central bank most.
It is not unusual to see the headline inflation, or the HICP as it is being called, to come to target, and yet the ECB to keep a dovish tone. Why is that? Because the Core CPI is lagging.
The CPI data is referring to the change in the values of goods and services at the consumer’s end. But before reaching the consumer, inflation is seen at producers first.
This makes the PPI (Producers Price Index) an interesting piece of economic data. It is misleading traders most of the times.
The reason for that is that in the economic calendars the PPI release is not even marked as an important economic data. It is shown as having a medium influence on currency prices.
In fact, it is extremely important, because the PPI tends to be released ahead of the CPI by a few days. A sudden, unexpected move in the PPI levels will be seen in the CPI in time, maybe not that month, but surely the next one/ones.
In other words, if traders are to position for a shift in the monetary policy because of changes in the inflation levels, that shift is going to start earlier than the actual CPI numbers are released. For that, looking at PPI pays.
This article is only intended to show the important role inflation has in the economy and the way it drives monetary policy and interest rates. The sooner the traders understand this correlation, the shorter the road to profitable trading is.