Forex Trading Library

“Base Effects”, CPI, and How to Gauge Central Bank Action

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The UK’s high inflation rate will come down next month, basically because of math. Typically, you can’t make these kinds of definitive predictions in the markets. But there is an underlying phenomenon to CPI figures that will have an important effect this year. And for traders trying to factor in how central banks will push currencies around, understanding this particular calculation would be very useful.

The UK has become an outlier among major economies with its inflation persistently in the double digits. So, this CPI calculation phenomenon is a lot more pronounced there, making it an easier case study. Understanding the exaggerated effect in the UK will make it easier to spot in other countries where it’s not so pronounced. Given the global nature of recent inflation trends, this applies to pretty much all major currencies (the yen and yuan are the notable exceptions).

What does “base effects” mean?

Investors and the market typically track the annual change in CPI, which is what we call inflation. This isn’t a direct, raw number, but a calculation based on underlying data. Each month, the government’s statistical department (in the UK, that’s the ONS) calculates the cost of a basket of goods and services, and weighs them in an index. That’s the “index” part of Consumer Price Index, or CPI.

Then the difference between each month is calculated in the form of a percentage, which gives us the inflation rate. Simple. Where’s the issue? The thing is, the inflation rate is determined by comparing the index from last month to the same month of the prior year. That prior year is the “base”. If there is a substantial change in the base, this will affect how the inflation rate is calculated for the current month. This is the effect that the base (that is, the inflation situation of a year ago) can have on current inflation calculations.

How does this affect inflation?

Let’s use the UK as an example. In March of 2022, UK CPI (that is, the index, not the rate) was 117.1. It then jumped to 120 in April of 2022, which was a 2.5% increase. Fast forward to March of 2023 (that’s the data we just got) the CPI was now 128.9, and the difference between the index now and what it was a year ago was 10.1%. Therefore, the inflation rate (CPI change) was recorded as 10.1%.

For inflation to stay at 10.1% for next month, then the consumer price index would have to increase by 2.5% to over 132. That’s not going to happen, for the simple reason that 2.5% monthly change in the CPI was the largest ever recorded, and was driven by an abrupt change in energy prices by Ofgem. So, because the base being used to calculate inflation next month will be higher, by comparison, inflation will be lower.

More importantly, what does this mean for currencies?

The change in CPI was very large through the early part of last year. Over the next couple of months, the comparison for calculating inflation will be to increasingly higher bases. Which will mathematically push inflation down, even though the current rate of inflation might be steady or actually increasing. As long as it’s not increasing faster than it was last year, it will appear as if it’s slowing down.

Central bankers are aware of this, and will likely adjust monetary policy accordingly. That is, even though inflation is still high, they might not be under as much pressure to keep raising rates. Because inflation will go down anyway, and they can claim it was thanks to their policy. This situation will be more pronounced in the currencies that saw big moves in inflation last year, such as the UK and the EU. Therefore, traders beware that these central banks might surprise the markets by not hiking as much as expected from the inflation numbers.

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