Consumer Price Index

Inflation is a measurement of increasing price levels. The inflation rate is the percentage at which prices of a basket of goods is increasing over a specified time period. The typical measurement of average price levels is the Consumer Price Index, or CPI. CPI is a constructed by evaluating the average price of all goods and services purchased from month to month. Inflation is thus determined by assessing the rate of change in the CPI. If the CPI is equal to 152.3 in November 2004 and in November 2005 it equals 156.8, then the rate that inflation is:

Inflation = [(156.8 - 152.3) / 152.3] x 100

Inflation = 2.95%

When inflation increases, there is an excess in the economies money supply. This will cause an increase in prices do to the inability of the supply of goods to meet its demand.. In other words there is too much money, chasing a limited amount of goods which will increase the price levels of the entire supply. Inflation decreases the purchasing power of consumers and has effects upon interest rates and the foreign exchange rate. If inflation is increasing more than the expected rate in one country and the rate of inflation in another country does not move with equality or with the same level of percentage change, the value of the currency in the inflation increasing country will depreciate in value. Therefore unexpected growth in the rate of inflation will have a depreciating effect upon the value of its currency.

Producer Price Index

The Producer Price Index (PPI) is a measure of the average level of prices of a fixed basket of goods received in primary markets by producers. The monthly PPI reports are widely followed as an indication of commodity inflation.

The PPI is considered important because it accounts for price changes throughout the manufacturing sector.

The PPI is often followed but excludes the food and energy components as these items are normally much more volatile than the rest of the PPI and can therefore obscure the more important underlying trend.

Studying the PPI allows consideration of inflationary pressures that may be accumulating or receding, but have not yet filtered through to the finished goods prices.

A rising PPI is normally expected to lead to higher consumer price inflation and thereby to potentially higher short-term interest rates. Higher rates will often have a short term positive impact on a currency, although significant inflationary pressure will often lead to an undermining of the confidence in the currency involved.