Economic data play an essential role in forex trading because they provide measures of the state of the economy. These numbers are used in fundamental analysis, which is one of the three methods that traders use to predict where a currency pair will move to.
In this article, we will focus on inflation data. We will explain what it is and how it works, how to use it in trading, and why it forms an essential role in fundamental analysis.
What is inflation?
Inflation refers to the overall change in the cost of items that people buy. These items include food, tobacco, alcoholic beverages, furniture, clothing, and gasoline, among others. Inflation happens when the price of an item rises in a given period.
For example, if a dress costs $100 today and $120 in the next two months, the change in price is 20%. In this case, if you have $100 today, you can get the dress. But because of inflation, you will not be able to afford the dress in two months if you only have $100.
Inflation is an important concept because it means that, over time, the value of a fiat currency like the US dollar or the euro will always go down. For example, in the 1950s, $100 was enough money for rent in some American cities. Today, it is almost impossible to pay for rent using the same amount.
The opposite of inflation is known as deflation. It is simply the situation where prices of items are falling. While many consumers would prefer a situation of lower costs, in reality, deflation is not the desired situation. For one, it is usually a sign that the economy is not doing well since demand is low. Also, it usually leads to a higher unemployment rate since companies are fetching a smaller amount of money for their goods.
Another term in measuring inflation in a country is known as stagflation. It refers to a situation when high inflation is accompanied by a high unemployment rate. It is one of the worst situations that a country can be in.
Inflation and unemployment rate relationship
In carrying out economic analysis, economists have found a close relationship between a country’s unemployment rate and inflation. For starters, the unemployment rate refers to the percentage of people of working age who are not working.
A concept known as Philip’s curve has been developed. Essentially, the argument is that a low level of unemployment rate leads to a higher rate of inflation. The argument of this is relatively simple. When the unemployment rate falls, it triggers companies to increase their wages. As a result, this leads to more consumption, which, in turn, leads to higher demand and then higher cost.
Still, at times, because of external factors, Philip’s curve does not work. A good example of this is in countries like Japan and Switzerland. While these countries have a history of low unemployment rates, their inflation rate has always been low. At the time of writing, Japan has an unemployment rate of about 2.9%, while its inflation is almost zero.
The Japanese situation is relatively easy to explain. See, the country’s labor market is relatively different from that of other countries since people tend to remain with the same employer for many years. At the same time, consumer spending tends to be low because of the aging population.
The impact of inflation data in Forex market
Forex traders often focus on inflation because of its impact on interest rates, which are usually set by a country’s central bank. Central banks like the Federal Reserve, European Central Bank (ECB), and the Bank of England (BOE) are given the mandate of ensuring that the unemployment rate remains low and that inflation is steady.
Therefore, a closer look at a country’s inflation is a good gauge of what to expect from a central bank. In most cases, a higher inflation rate leads to higher interest rates or a hawkish central bank. On the other hand, a lower inflation rate tends to lead to a dovish central bank. This is important since actions by a central bank are the most important movers of currency pairs.
There are several gauges of inflation that forex traders look at, including:
- Consumer price index (CPI) – CPI measures the overall change of prices of most items like fuel and furniture. Many countries, like the US and UK, usually publish this data every month.
- Producer price index (PPI) – The PPI measures inflation from the angle of a producer. In most cases, higher PPI data tends to translate to a higher CPI rate.
- Personal consumption index (PCI) – This data comes from the United States only. The number shows the overall increase in individual consumption. A higher figure is a sign of higher inflation.
- Retail sales – The economic indicator measures the volume of goods sold in a certain period. In most cases, countries publish these numbers every month. Higher retail sales are a sign that consumers are increasing their spending. As a result, it is a sign that consumer prices will keep rising.
- Wholesale price index (WPI) – WPI measures the change of prices of goods sold by wholesalers. While it is an important number, it is not tracked closely by investors.
How to trade using inflation data
Trading using inflation numbers is a relatively simple thing. First, you need to be aware of when the data is coming out. The economic calendar will help you know when this data will be released.
Second, you need to have the historical context of inflation. For example, you should know what the central bank said about inflation recently.
Sometimes, strong inflation data can be accompanied by a little change in a currency pair. For example, if the Fed has committed not to hike rates for a while, the short-term inflation data will not have a major impact.
Third, you should factor in inflation expectations. Some of the most popular inflation expectation numbers are bond yields and the five-year breakeven point.
As a trader, you cannot ignore the concept of inflation since it is one of the most important data in the economic calendar. In this article, we have looked at what inflation is, the concept of Philip’s curve, the key inflation gauges, and some of the key steps to use when using the data to trade.