What is Consumer Price Index or CPI? How does it influence currency exchange rates?

If you go to a supermarket to buy groceries every month, you can sometimes find yourself check whether the same things were less or more expensive the last month. In other words, you keep on eye on your costs of living - whether they’re increasing or decreasing.

In the same way, if you want to check whether the overall cost of living in your country has increased or decreased in the last couple of months, the one important figure you would look at is consumer price index, or CPI.

CPI is one of the most efficient and popular ways of measuring price levels of goods and services that important for your daily life. But, what is CPI? How does it measure cost of living? And, why is it a good measurement of cost of living? And what does the related term WPI have to do with all of it?

This article is going to answer exactly these questions, and a little more. Before we can look at how CPI measures costs of living, though, let us get a little more understanding about what it means and why it’s around.

What is CPI? What does it stand for? And what does it measure exactly?

CPI, or consumer price index, measures the price you pay for a certain class of goods and services that you regularly buy as a common consumer. There are thousands, if not millions, of goods you can buy. It would be nearly impossible to measure the price changes of all the goods available every month, or even every year. Consumer price index doesn’t measure all these goods, but, instead, a select number of goods. The goods that get measured are ones economic experts deem important to the country’s consumer households.

Sometimes the CPI’s group of measured goods is referred to as a basket or market basket.

This basket is an imaginary basket, of course. And what goes into this basket is goods considered important. Initially, when governments measured price changes, they only included a few dozen items in this basket like beef, leather, wool, corn, etc. These days, however, to match ever-changing consumer behavior and purchases, what’s in these market baskets has changed quite a bit.

If we hope for CPI to accurately track spending habits of everyday consumers, the contents of that basket is very important. The CPI should accurately track price changes of goods that local households actually care about. In smaller countries, only about 100-200 goods are calculated into the CPI. Whereas in larger countries, like the UK and the USA, thousands of products are included.

What goes into this basket also reflects the cultural trends of that country. For example, economists in the UK decided to add rosé wine and takeaway chicken into the basket in 2009, and removed volume bottled cider and boxes of wine. They did this so that the basket resembles what regular households in the UK actually spend their money on. This is why CPI is not only a very reliable measure of changes in a regular household’s cost of living, but also a good way to track cultural changes in spending habits of a country.

The calculation involved in the CPI of a country is quite sophisticated. The agencies performing this calculation divide the population into various categories and subcategories. This is to reflect different classifications that exist within the population in their buying habits. For instance, categories like urban or rural are separated because households in cities spend differently when compared households in towns and villages. Based on these obtained indices and sub indices, the final overall price index is calculated mostly by national statistical agencies. It’s one of the most important statistics for an economy and is generally based on the weighted average of the prices of commodities. It gives an idea of the cost of living.

How do you read a CPI figure?

Suppose you read somewhere that the CPI of country X is 120 in 2016. What would that mean?

CPI always starts with a base year for comparison. For the sake of the example, let’s say that, for country X, the base (comparison) year is 2012. That would mean that the total consumer prices of goods for country X in 2012 is equalized to 100 points on the CPI scale. If the 2016 CPI was 120, that would mean that, in 2016, the prices in that country increased by 20% from the base year 2012.

How do CPI figures influence currency exchange rates?

So, we know that CPI shows how expensive or cheap cost of living in a country is getting. But does it also influence the value of that country’s currency?

The short answer is yes.

CPI figures enormously impact the value of currencies as well as the relationship of a one currency to another. Currency traders always keep a close watch on not only monthly CPI figures from a country, but also estimates by experts about what the monthly CPI will be. If the CPI results don’t match experts’ estimates, there’s usually a very volatile response from the currency of that country. But why does CPI affect the value of a currency at all?

As you well know, prices change all the time. These variations could be related to many things - local politics, natural disasters, market fluctuations, foreign country policy changes, and more. Regardless of the reason, when the price of goods and services go up and then stay up, it’s what experts call inflation.

Inflation is a bit complex and has wide-ranging effects on a country’s economy. One of the best measures of a country’s inflation is CPI. This is because, as we already know by know, CPI gives the best estimate of how much you’re going to spend on your usual monthly shopping. By this, the CPI can indicate whether the value of your money is going up or down. In other words, it indicates whether the same amount of money is going to get you more goods and services or less - which is exactly what inflation is about.

Inflation, in turn, is a very important factor in the decisions that central banks make.

When inflation is too low, the central bank of that country usually reduces interest rates. And, on the flip side, when inflation is high, it usually raises interest rates.

When a central bank increases interest rates, households are more inclined to keep their money in the bank because of the higher returns. But raised interest rates also makes for an increased demand for that currency in the foreign exchange market. This is because if you get higher interest rates for a certain currency, then you’re more likely to invest your money there. As a result, the demand and value of that currency usually rises following an interest rate hike.

This is why investors keep a close watch at inflation figures of a country. And because CPI is one of the best indicators of inflation, each CPI release is usually followed by a fluctuation in demand for a currency.

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