Gross domestic product (GDP) is the total monetary or market value of all the

finished goods and services produced within a country's borders in a specific time
period. As a broad measure of overall domestic production, it functions as a
comprehensive scorecard of a given country’s economic health.

Though GDP is typically calculated on an annual basis, it is sometimes calculated

on a quarterly basis as well. In the U.S., for example, the government releases an
annualized GDP estimate for each fiscal quarter and also for the calendar year. The
individual data sets included in this report are given in real terms, so the data
is adjusted for price changes and is, therefore, net of inflation. In the U.S., the
Bureau of Economic Analysis (BEA) calculates the GDP using data ascertained through
surveys of retailers, manufacturers, and builders, and by looking at trade flows.
Economic Indicators and Monetary Policy
All economies go through cycles.

Each business cycle has certain characteristics. This is where the three most
important economic indicators come into focus.

These indicators can reveal in which business cycle an economy is in. Central banks
make monetary policy decisions based on their economy’s current business cycle.

Thus, by following economic indicators traders can anticipate future policy

adjustments.

There are a couple of tools central banks use in adjusting monetary policy. The
most important one for Forex Traders are Interest rate adjustments.

Interest rates are one of the biggest factors the market uses to determine the
value of a currency.

When interest rate expectations go up or down currency values normally change

accordingly. There are some exceptions to this rule but that is generally the case.

Based on CPI, GDP and the Unemployment rate traders can anticipate interest rate
adjustments.

Therefore, these three economic indicators are very important for Fundamental
Analysis.

Consumer Price Index (CPI)

What Is CPI
CPI measures the change in average prices of a fixed basket of goods and services
within an economy.

According to Investopedia, it’s the “most widely used measure of inflation”. CPI is
often referred to as the “cost of living” as it affects the future value of money.

The CPI compares the current cost of a basket of goods to the same basket of goods
in a different period. For example, a CPI YY reading measures the change in prices
of a specific basket of goods from one year to the next.

The things measured include food, housing, clothing, transportation, education,

communication, energy and healthcare.

When the price of these goods and services are increasing we refer to it as
inflation. When the costs are decreasing we refer to it as disinflation.

Headline CPI numbers can fluctuate a lot due to things like energy and food costs
which can be volatile. For this reason, most central banks prefer Core CPI as their
gauge of inflation.

Core CPI is inflation excluding volatile energy and food costs.

Why Central Banks Care About Inflation

What is the big deal about inflation you may ask? Well, inflation directly impacts
the value of the money you have in your wallet.

Due to inflation, the prices in the United States in 2018 are 947.46% higher than
in 1950! That means that you will need to have approximately $1,047.46 in 2018 to
match the buying power that a $100 had in 1950.

There is an obvious benefit for consumers to keep inflation as low as possible.

Lower inflation means the money people have has more buying power.

There are other good reasons for governments to want to keep inflation low and
stable. Uncontrolled inflation can lead to economic catastrophes like
hyperinflation.

Popular examples of this was Germany (1920’s), Zimbabwe (2000’s) and more recently
Venezuela. Hyperinflation can cause prices to double every 24 hours!

Imagine going to the shop and seeing the price of a loaf of bread double every day.

The IMF has warned that Venezuela’s inflation may rise above 1 million % in 2018.
Imagine having to pay billions or trillions of dollars for a packet of crisps.

CPI And Monetary Policy

Catastrophe’s like hyperinflation caused central banks to rethink their approach
towards inflation. This is where things like Inflation targeting came into play.

What exactly is inflation targeting? This is when central banks use monetary policy
to keep inflation close to an agreed target.

The RBNZ became the first central bank to adopt inflation targeting in 1990. After
the RBNZ many other central banks have adopted the same approach.

The BOC explains there are three benefits to keeping inflation at a low target:

The economy makes better long-term plans as there is confidence in the future value
of money
Lower inflation means lower interest rates which leads to economic expansion
Long-term low inflation means the economy is more resilient to transitory price
spikes.
The UK is a recent example of central bank intervention due to inflation targeting.
In June 2016 the UK Brexit referendum saw the value of the Pound drop
substantially.

Import prices for products shot up as the value of the Pound sank over 10%. The
rise in import prices caused UK inflation to rise to 3%.

The BOE has an inflation target of 2%. In order to curb a further rise in inflation
the BOE hiked interest rates.
It’s important to note that low inflation can be negative in the long run if it
leads to deflation. Deflation is a general decrease in price levels within an
economy.

Deflation is a major hurdle for economic growth and expansion. When consumers think
prices are going down, they will hold back from spending.

Japan’s fight with low inflation for the last two decades is testimony to the risks
of deflation.

Relationship Between CPI And Interest Rates

Interest rate adjustments has indirect effects on inflation.

High interest rates discourages businesses and consumers from borrowing and
spending. This leads to lower demand for goods and services which ultimately leads
to lower prices.

The exact opposite is also true. Lower interest rates would cause consumers and
business to spend and borrow. This drives up aggregate demand which leads to higher
prices.

The above image provides a graphic illustration of how interest rates indirectly
affects inflation.

How can all of this help us in our Fundamental Analysis and our trading?

We know price stability is one of the common mandates shared by most central banks.

If inflation rises too fast, central banks might combat it by raising interest
rates. If inflation drops below target, they might lower interest rates to boost
inflation.

Moves in inflation directly effects interest rate expectations. Thus, by tracking

CPI, traders can anticipate possible interest rate adjustments.

But inflation is only one part of the puzzle which brings us to our next economic
indicator.