Inflation: CPI, PCE, HICP and their impact on currencies

Inflation is the general rise in prices. For a consumer, it means the same basket of groceries costs more. For a trader, it's above all a signal: it tells you what the central bank is likely to do with rates. And rates, as we've seen, are the number one driver of currencies.

The inflation, rates, currency chain

Most major central banks target inflation of around 2%. When prices rise faster, they raise rates or keep them high to cool demand. When inflation drops below target, they can cut. Every inflation release therefore shifts the bets on upcoming decisions.

This chain holds in the short term in the vast majority of cases. It can break if the market thinks the central bank won't react, for example because the economy is already in recession. In that case, high inflation becomes bad news for the currency.

The main indices to know

The US CPI tracks price changes for a basket of goods and services bought by urban households. The PCE covers a broader scope, including for example healthcare paid by employers, and adjusts weights better when consumers change their habits. The Fed targets PCE, but the market often reacts more strongly to CPI because it comes out earlier.

In the eurozone, the HICP is published by Eurostat. Its quick flash estimate comes out at the end of the month in question or in the first days of the next one, and that's the release that moves the euro. National figures, such as those from Germany or France, released just before, often give a preview.

Headline or core inflation?

Headline inflation includes everything, energy and food too, whose prices are very volatile. A spike in oil can push it up in one month and drop it the next. Core inflation strips those out to show the underlying trend.

Central banks mostly watch the underlying trend, because it's harder to bring down. So don't be surprised if the market ignores rising headline inflation but reacts sharply to core CPI above consensus. That's often the line that decides the direction.

Reading a release in five points

1. The consensus: the average of economists' forecasts. The market has already priced it in.
2. The actual figure: compare it with the consensus. The gap, even a tenth of a point, drives the reaction.
3. Monthly versus annual: the month-on-month change shows recent momentum, while the year-on-year change can be distorted by base effects (a very strong or weak month a year earlier).
4. Headline versus core: if they point in opposite directions, core usually wins.
5. Revisions: the previous month's figure can be corrected. A big revision changes the reading.

Which pairs to watch?

A US CPI release moves every dollar pair, and gold too, which pays no interest and suffers when yields rise. US inflation hotter than expected tends to push USD/JPY up and XAU/USD down. For the HICP, watch EUR/USD and EUR/CHF; for UK CPI, GBP/USD and EUR/GBP.

The key is to pick a pair where the two economies don't release data on the same day. Otherwise, you risk reading two surprises at once and not knowing which one is moving price. The simpler your scenario, the clearer your read of the reaction.

Also keep an eye on producer price inflation, published in most major economies. It measures prices paid by businesses and can signal, a few months ahead, increases that will be passed on to consumers. It moves the market less, but it helps you prepare for the next CPI release.

Classic traps

Trap one: confusing level and surprise. Inflation of 4% can sink the currency if the market expected 4.3%. Trap two: forgetting the context. If the central bank has already signalled it won't move, a small surprise will have a limited effect that fades quickly.

Trap three: trading the first move. In the seconds after the release, algorithms react to the headline figure, then the market digests the details. It's common to see a first spike one way, then a reversal once traders read core and the revisions.