The consumer price index (CPI) is a measure of the price of a weighted average basket of consumer goods and services. The CPI is then calculated by taking price changes for each item in the predetermined basket of goods and services, and averaging them. Changes in CPI are used to gauge price changes associated with the cost of living. The CPI for an economy is computed on a monthly or quarterly basis by public sector organisations within that economy. For example, in the US the CPI is computed by the Bureau of Labor Statistics.

The Consumer Price Index is one of the leading indicators of an economy’s health as consumer prices account for a majority of the overall inflation in an economy. Increases in the CPI during a short period of time typically indicate periods of inflation and decreases in CPI during a short period of time usually signal periods of deflation. An increase in the general level of prices or an increase in inflation implies a decrease in the purchasing power of the currency. When the general level of prices rise, each monetary unit buys fewer goods and services.

Central banks generally attempt to limit inflation, and avoid deflation, in order to keep the economy running as smoothly as possible. Therefore, inflation is important to currency valuation because rising prices lead central banks to raise interest rates out of respect for their inflation containment mandates and rising interest rates impacts the exchange rate between two currencies.

In the forex markets we are essentially trading the exchange rate of the currencies between two economies. However, inflation is just one factor among many that combine to influence an economy’s exchange rate. A very low inflation rate will not necessarily impact an economy’s exchange rates in a positive way. However, an extremely high inflation rate is likely to have a negative impact on the economy’s exchange rates. Countries attempt to balance interest rates and inflation, but the relationship between the two is complex and often difficult to manage.

We as technical analysts prefer to remain objective focusing on price action and identifying probable breakouts in the market place. We specifically target markets that are range bound for prolonged periods of time and when such a market finally breaks out of that range, the breakout tends to be aggressive. The patience required waiting for these breakouts to occur rewards the trader handsomely when it finally materialises.

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