The Consumer Price Index is one of the principle economic indicators traders and investors use to assess the likely future exchange rate from pounds to dollars. The reason is very simple – CPI data provides a measure of inflation, and as such provides the basis for interest rate decisions by the Bank of England. In looking at any economic indicator, it is important that you remember one thing ( which is not just me being an old cynic!) – all these indicators present data on behalf of the government to show how well, or how badly the economy is performing. Each and every government will therefore attempt to present the data in the most favourable light, either by changing the basis of the indicator concerned, or by including or removing data which might otherwise provide a more precise and accurate picture reflecting the real economy, rather than a ‘massaged’ view. This has never been seen more often than in the changes made to CPI  over the years, both in name and in what is included ( or more importantly excluded!) Remember, there are three types of lies – lies, damned lies and statistics. Now in case you are a little skeptical, let me briefly explain how this indicator has changed in the last 10 years.

For many years, it was originally called the RPI or Retail Price Index which was first used in the early 20th century. In the early 1990’s the figures were calculated excluding mortgage interest payments, as it was argued that if interest rates were used to manage inflation, then including these interest payments would be misleading. At the time it was called the RPIX. In 1996 the current CPI was introduced and in December 2003 the inflation target was moved to one based on the CPI data set – why?- simple – it is more favourable for the government! RPI and RPIX are likely to be higher and therefore a more realistic indictor of current economic conditions. If you don’t believe me, just consider the latest set of figures for inflation. The UK Government has set a target of 2.0% and in the latest results, CPI came in at 2.5%, RPIX at 3.7%, and the old RPI at 4.1% – I think the figures speak for themselves.

So what is CPI, and why is it so important to us as traders and investors in looking at our pounds to dollars conversions? In simple terms, CPI is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, clothing, and medical services. The actual figure is calculated by taking price changes for each item in the pre-determined basket of goods, and averaging them out. Each item is then weighted according to it’s importance in the basket, which are then aggregated to provide a measure of price changes in the period, and hence the cost of living. The data does not include any mortgage interest payments ( these are included in the RPI figures, but not in RPIX!) This is then equated to a headline inflation rate. The figures are released monthly by the Office For National Statistics on a monthly basis, at 8.30 GMT. The most useful way to think about CPI and RPI is to imagine a shopping basket filled with the goods and services that people typically spend their money on during the month. The basket of goods is changed annually as new products come into the market and others fall out of fashion. However the core groups remain the same of which food and alcohol,  transport costs ( fuel etc) , recreation, and restaurants and hotels have the greatest weighting. Now, if you collected together 100 economists from 10 different countries, the only things they would agree on would be the following :

  1. That CPI as a measure of inflation is probably wrong!
  2. That there must be a better way to measure inflation
  3. That all governments around the world have the same problem
  4. That all governments ‘manage’ the data to show inflation in a favourable light!

So, if it is generally agreed that the data is inaccurate at best, and really only designed to provide the government with a tool with which to manipulate figures, why do the markets react so strongly as soon as the figures are announced. The simple answer is that until something better comes along, this is all we have available. However, I would urge you to look a little deeper into the figures once they are announced, and to use your own common sense. As a trader, look at both the RPI and RPIX, which will give you a much better idea of inflation and the likelihood or otherwise of interest rate changes. Look at the broader markets such as basic commodities – if the costs of staple commodities such as oil, wheat, and barley, or raw materials such as copper and iron ore are increasing, then you can bet that at some point soon, these costs will filter their way through to you on the high street, resulting in higher costs in the basic basket of goods and services. The prospect of inflation raises the possibility of  interest rate increases, except where we have stagflation ( which is where we are in the UK and US at present – the worst of all worlds!!) where we have a stagnant economy, but rising inflation. The same situation is occurring in the US economy, and is very similar to the pressures experienced during the 1970’s, with central banks loathe to raise rates which could stall the economy completely and result in a crash. Only time will tell when rates will settle, but my view is that the US rates will reach 1.5% -2.0%, whilst UK rates will drop to around 3% minimum.