At first glance, the concept of Fundamental Analysis might seem very daunting. The truth is that it’s a lot simpler than most people think.
Fundamental Analysis is simply a way of evaluating the state of a country’s economy. The biggest part of economic analysis is based on economic indicators.
There are hundreds of indicators released for each individual country. For some traders the idea of keeping track of all of them is very intimidating.
The good news is that you don’t have to do this. Basic Fundamental Analysis revolves around three key economic indicators.
These three indicators are CPI, GDP and Unemployment.
In this article, we will elaborate on the importance of these three indicators. We’ll also explain why they are important for our trading and analysis.
The points we’ll discuss in this article are:
Why Economic Indicators Are Important in Fundamental Analysis
What is the big deal about economic indicators? They are important because central banks use them to measure the health of an economy.
Every central bank will have different mandates, but they all share common goals. These goals are stable prices, fair currency values, low unemployment and stable economic growth.
During times of economic hardship more money is required to stimulate expansion. During economic booms, less money is needed to stop an economy from overheating.
Economic Indicators and Monetary Policy
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.
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.
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.
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.
Gross Domestic Product (GDP)
What Is GDP
GDP is the total monetary value of all goods and services produced in a country during a specific period. GDP growth is the rate of change of GDP when compared from one period to another.
It’s the most “commonly used measure of economic activity“. GDP is used as a gauge by central banks to track a country’s economic health.
There are three ways in which GDP can be calculated. The most widely used method is called the “Expenditure Method“.
This method combines total consumer spending, government spending, business investment and net exports.
The above image better illustrates how GDP is calculated using the Expenditure method.
Nominal GDP numbers can be artificially inflated due to things like inflation. If inflation was 10% in one year and 2% in another the change in prices will skew GDP numbers.
Higher general price levels in one year means it would cost more to produce goods and services. Compared to a year where lower price levels means goods and services cost less to produce.
The cost to produce goods and services can thus inflate or deflate the end-product prices.
That is why Real GDP is so important. Real GDP is a much more accurate measure as it is GDP adjusted with inflation.
Real GDP compares economic growth at constant general price levels. This strips out inflated or deflated general prices from one year to another.
For this reason, most central banks prefer using real GDP as their gauge of economic growth.
Why Central Banks Care About GDP
Stable and sustainable economic growth is very important to central bankers. Some scholars believe that the ideal GDP growth rate is between 2% and 3%.
The average GDP for the world economy in 2017 was 3.15%. From 1961 to 2017 the GDP for the world economy averaged 3.52%.
GDP growth can differ drastically from one economy to another. In 2017 Lybia had GDP growth of 26.68% compared to Congo that had negative GDP growth of -4.59% in the same year.
Much like inflation, GDP growth should be stable for the best outcome of an economy. Too low or too high growth rates can both have detrimental effects on an economy.
There are a number of benefits to keep GDP stable and sustainable namely:
- Increase in living standards
- Decrease in unemployment
- Lowers government borrowing
- Increase in business investment
The opposite of this is also true. When GDP growth is too low or too high it can have the opposite affects.
GDP And Monetary Policy
GDP growth can be a tricky thing to manage for central banks. Monetary policy needs to be able to support both expansionary and contractionary requirements.
Supply and demand economics help us to understand this a lot better.
Low economic growth means reduced economic activity. With low economic activity companies require less workers to meet production demand.
This leads to higher unemployment. Less employment mean less people have money to spend.
In turn this drives down the demand for goods which reduces prices (inflation). In such a case the economy will require expansionary monetary policy.
What about an economy where growth is high? Isn’t growth a good thing?
It’s only good when it’s sustainable. High economic expansion leads to increased business activity.
This means more companies require workers to meet the increasing demand for goods. The impact of this is lower unemployment as more people enter the job market.
The higher employment means more people have money to spend. This drives up the demand for goods and services even more.
As demand for goods and services increase prices start to go up. If this escalates an economy can overheat causing inflation to soar.
Relationship between GDP and Interest Rates
GDP growth is considered as a procyclical indicator. Procyclical means it moves in tandem with the economy.
If the economy is doing well, GDP growth should be good as well. On the other hand, if the economy is doing bad, the growth number should be bad.
How does all of this relate to Interest Rates? This brings us back to the business cycle. Every business cycle will require different interest rate policies.
High or low interest rates means higher or lower borrowing costs. When borrowing costs are too high, businesses don’t borrow money to invest and expand.
This leads to less people employed in the work force. Reduced employment means reduced private consumption.
Contrastingly, when the cost of money is cheap businesses take advantage to invest. This leads to more work and more private consumption.
Why exactly is business investment and private consumption so important to GDP?
According to The World Bank, about 60% of total GDP comes from private consumption alone. The numbers differ from country to country.
For example, in the US private consumption forms 70% of GDP. Whereas in the EU it only makes up about 57%.
The important point here is that consumer spending forms a massive part of a nation’s GDP. If interest rates cause businesses to cut back it directly affects consumption.
Slowing economies normally require interest rate cuts to stimulate growth. Overheating economies normally require interest rate hikes to cool down growth.
If growth rises too fast, central banks might combat it by raising interest rates. When GDP drops significantly, they might lower interest rates to boost growth.
Moves in GDP directly effects interest rate expectations. Thus, by tracking GDP, traders can anticipate possible interest rate adjustments.
What Is The Unemployment Rate?
The unemployment rate is the percentage of unemployed workers in the labor force. People are considered unemployed if they are able and willing to work but does not have a job.
The unemployment rate is a countercyclical indicator. This means it decreases in a growing economy and increases in a slowing economy.
According to the RBA, there are three different types of Unemployment. These three are Structural, Cyclical and Frictional Unemployment.
Low unemployment is one of the key mandates of many central banks. Higher employment means people have more money to spend.
Having more money to spend means an increase in the standards of living. BUT, low unemployment is not always a good thing.
Did you know that the US economy fell into recession in three of their last four hiking cycles? In these four cases some believe the FED allowed the economy to overheat.
Some say rapidly advancing wages due to low unemployment caused an overheated economy. This caused the FED to hike rates very rapidly which caused the recessions.
That is why too low unemployment can be just as bad as too high unemployment.
Why Central Banks Care About The Unemployment Rate
The answer to this question brings us back to inflation and growth.
In 1958 A.W. Phillips made an important economic observation. His research showed that there is an inverse correlation between inflation and unemployment.
His theory was called the Phillips Curve. The Phillips curve showed two things:
- High unemployment results in low inflation
- Low unemployment results in high inflation
The theory revealed the importance between aggregate demand (growth), unemployment and inflation. When policy caused economic growth more jobs are needed.
More jobs mean more money in people’s pockets which means more spending. The increase in spending increases the demand for goods which increases inflation.
Many central banks adopted the Phillips Curve theory to guide monetary policy. But the stagflation of the 1970’s and the boom of the 1990’s showed there was a disconnect in the theory.
During the 1970’s there was high inflation accompanied by high unemployment. During the 1990’s there was low inflation accompanied by low unemployment.
This led economists to find reasons for the breakdown of the Phillips Curve. Economists Milton Friedman and Edmund Phelps came up with a theory to explain this.
They argued that the Phillips curve was only reliable and accurate in the short run. In the long run, unemployment will always settle at a “natural rate” despite the inflation rate.
It’s also referred to as the NAIRU (non-accelerating inflation rate of unemployment). This is the unemployment rate to which an economy will naturally gravitate towards.
The natural rate of unemployment for developed countries is believed to be between 4.5% and 5.0%. An unemployment rate equal to the natural rate is considered as full employment.
Relationship Between Unemployment And Interest Rates
We know central bankers are concerned about high and low unemployment. Both can cause severe consequences on an economy.
For this reason, unemployment is a very closely watched indicator by central banks. Not only because it forms part of their mandates, but because of its effects on an economy.
Changes in the employment levels act as a barometer for economic health. A healthy economy boasts low unemployment and struggling economies have higher unemployment.
This is due in part to wages. When an economy is healthy and labour markets are tight workers can expect higher wages.
Wage inflation is one of the major reasons for increases in inflation. This is because wages can affect both cost-push and demand-pull inflation.
Cost-Push Inflation: Increased labour costs pushes up production costs causing businesses to raise prices.
Demand-Pull Inflation: As workers earn more they spend more. When the increase in demand for goods surpass the supply, prices increase.
The ECB considers wage growth as a precondition for sustained increases in inflation.
Contrastingly, central banks are also worried about high unemployment for the opposite reasons.
If wages don’t rise in step with inflation it will impact consumer spending. A drop in consumer spending will cause a slowdown in economic growth etc.
All this info gives traders a unique advantage in their Fundamental Analysis.
Strong labour markets normally require higher interest rates. Whereas weaker labour markets normally require lower interest rates.
The infamous Non-Farm Payroll (NFP) is testament to the importance of labour data. The NFP is probably the most watched and traded news event of any other indicator.
This is not surprising considering that unemployment is such a big focus to the FED.
Putting It All Together
From the above information one can easily see that central bankers have very difficult jobs.
Their monetary policy decisions guide economies through various business cycles. Central banks need to make tricky decisions to achieve ideal economic conditions.
Some economists believe the ideal conditions for developed economies are namely:
- Real GDP growth of between 2% to 3%
- Core Inflation close to 2%
- Unemployment rates of between 4.5% to 5.0
The challenge is that GDP, inflation and employment are all connected and intertwined. A fall or rise in one of those three directly or indirectly affects the others.
That is why these three indicators are the most important ones for traders. They provide essential fundamental pieces of the economic puzzle.
By following these indicators, we can anticipate future interest rate moves.
Action To Take
What can you do to start using these three indicators in your Fundamental Analysis?
- Find an economic calendar and see when any of these three indicators are released.
You will be able to find plenty of free economic calendars available on the internet. Your broker may even have one of their own as well.
- See how the markets react when these three indicators are released.
Make sure to read analyst remarks about these releases before and after the events. This will give you an idea of how the market relates to these events.
It will also help you gain insight about which elements are important.
- Start to build a big picture view of monetary policy.
Try and anticipate which actions central banks might take due to incoming data. In the beginning read up on investment bank analysis about future interest rates.
This will give you a framework for how the markets analyse and forecast interest rates.
By following these three simple steps can help you in your Fundamental Analysis. Plus, once you have the basics in place you can expand your knowledge of other indicators.
We wish you all the best with your Fundamental Analysis.
If you have any questions or comments, feel free to let us know in the comment box below.