The Consumer Price Index (CPI) is a broad measure of inflation within an economy in relation to the cost of goods and services. That figure can have a significant impact on the value of a currency in relation to the currencies of other nations.

The CPI calculates the weighted average of prices of a basket of consumer goods and services, including costs of transportation, food and energy. Economists use this CPI figure to assess price changes in individuals’ cost of living.

When inflation is too low, a central bank like the Federal Reserve may cut interest rates in order to spur economic activity. When inflation is too high, interest rates may be raised to stabilize prices. By increasing interest rates, a consumer may be more likely inclined to save money, rather than spend it, due to the return they may generate by keeping it in a bank.

In the foreign exchange (forex) markets, the monthly CPI measure is a one of the most important indicators monitored by traders. In the case of the U.S. dollar, the release and revisions of the CPI figure by the Bureau of Labor Statistics can produce swings in the dollar’s value against other currencies around the world. (See also: How does inflation affect the exchange rate between two nations?)

This article explains how CPI data affects the relationship between the dollar and its pairings with other currencies on the forex market.

Why the CPI Matters to Currency Traders

Markets typically refer to the CPI indicator as “headline inflation.” This CPI data is critical in the currency markets because inflation dramatically impacts the decisions made by central banks regarding monetary policy. (See also: What are Central Banks?)

Given that central banks typically have a mandate to control inflation at a suitable level (the Federal Reserve and the Bank of Japan have both targeted an inflation rate of 2.0% annually), policy makers raise or lower interest rates as a mechanism to reach these target levels. They may also introduce other policy prescriptions such as bond-purchasing agreements or the expansion of the money supply.

Should inflation levels deviate from target levels, it is a possible indicator that central banks like the Federal Reserve may alter interest rates. If inflation rises above that 2.0% target, the Fed may raise interest rates in order to cool down spending. That will strengthen the dollar against other currencies as a higher interest rate makes the greenback more desirable. (See also: What do the terms weak dollar and strong dollar mean?)

It is also a forward indicator on an economy’s performance. Should inflation rise sharply like it has in countries such as Brazil and Venezuela in recent years, consumers will be less inclined to save money as their purchasing power erodes. (See also: The Impact Of Venezuela's Bolivar Exchange Rates).

Meanwhile, when a central bank hikes interest rates to combat inflation, borrowing, whether by individuals to purchase goods and services or by businesses for the purposes of expanding, will typically contract. This can impact the broader gross domestic product of a nation.

How CPI Data Affects the Dollar on the Forex Market

The Federal Reserve has a dual mandate that affects its actions on monetary policy. The central bank wants to bring the economy to full employment and it wants to ensure a healthy rate of inflation as the economy expands. Under Federal Reserve Chair Janet Yellen, the central bank has set a target of 2.0% for inflation.

As a result, forex traders see both unemployment and inflation figures as figures that will dictate the central bank’s future decision on whether to cut, raise or maintain current interest rate levels. Given the impact of an interest rate on the strength or weakness of a currency, traders can anticipate the impact of the central bank’s actions and the impact on the dollar’s performance in currency pairs.

Forex traders consider the CPI and Core CPI figures to be two of the most fundamental indicators for the performance of an economy. Among the two, however, the Core CPI figure provides a better look under the hood by excluding costs in the energy and food sectors, which tend to experience greater price volatility over time.

In the United States, the Labor Department releases the CPI and Core CPI figure, which doesn’t include costs of energy or food in the measure. Should that number beat market expectations, the dollar typically sees a boost against other currencies. However, should these readings fall short of consensus expectations, the currency will fall relative to other pairings.

However, the impact is not limited to the monthly report. Like all government data figures, the CPI figure is subject to revisions by economists. Such changes can fuel significant volatility in a currency's value on the global market. 

The Bottom Line

The Consumer Price Index (CPI) is a critical indicator of pricing pressures in an economy and provides a gauge of inflation. Forex traders monitor the CPI, as it can lead to changes in monetary policy by the central bank that will either strengthen or weaken the currency against rivals in the markets. The strength or weakness of a currency can also have a significant impact on the earnings performance of companies with a presence in many global markets. (To learn more, read How A Strong Greenback Affects the Economy.)

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