USING PPI TO TRADE FOREX: TALKING POINTS
PPI stands for the Producer Price Index, which is an important piece of economic data
PPI data is released during the second week of each month.
Forex traders can use PPI as a leading indicator to forecast consumer inflation measured by the Consumer Price Index (CPI).
PPI is an important piece of economic data due to its signaling effect on future expected inflation. Traders monitor PPI in forex trading because of the positive relationship between inflation and interest rates, but ultimately, traders are concerned with how the resultant interest rate changes are likely to affect currency pairs. Continue reading to learn more about the PPI index and how it affects the foreign exchange market.
WHAT IS PPI AND WHAT DOES IT MEASURE?
PPI stands for Producer Price Index and measures the change in the price of finished goods and services sold by producers. PPI data represents the monthly change in the average price of a basket of goods purchased by manufacturers.
How is PPI calculated?
PPI examines three production areas; commodity-based, industrial-based, and stage-of-processing-based companies. Released by the Bureau of Labor Statistics, PPI is created using data collected from a mailed survey of retailers selected via a process of systematic sampling of all firms listed with the Unemployment Insurance System.
Traders can see changes in PPI expressed as a percentage change from the previous year, or on a month to month basis.
PPI and inflation
A positive change in the PPI index implies that costs are rising and, in the end, price increases get passed down to consumers. If this effect is large enough, there will be an increase in future CPI figures to reflect that the general level of prices has increased.
Inflation and the effect on the economy
An increase in the general price level is good for an economy but only when this is contained. When demand for goods and services increases, businesses must increase capital expenditure and hire more workers in order to increase their output to meet higher demand. The problem arises when prices increase drastically, resulting in a decrease in the purchasing power of a country’s currency. $1 can buy less than it could one year ago, for example.
In the 1950s, gasoline was $0.27, while apartment rent was $42/month and a movie ticket was $0.48. These figures are nowhere near to where they are today, and this reflects how inflation erodes the value of local currency. In an attempt to combat the erosion of purchasing power, central banks effectively reduce inflation by raising the benchmark interest rate.
HOW DOES PPI IMPACT CURRENCIES?
When it comes to money there is always a trade-off: individuals can save money and earn interest, or they can spend money immediately and forgo any interest payments.
If PPI is on the rise it may cause the interest rates to rise. When interest rates go up, electing to save money looks more attractive as the reward (interest) is greater than before. Spending money becomes costlier because consumers would effectively be losing out on the higher interest rate when they choose to spend money instead of saving. As a result, increased PPI may filter down into increased rates and a stronger currency.
Using the Euro as an example, forex traders know that higher interest rates results in increased financial flows by foreign investors wanting to buy the higher yielding Euro. This effect tends to drive the value of the Euro up as the demand for the Euro has increased.
A popular strategy chasing higher interest rates is the “carry trade” strategy; whereby traders borrow funds in a currency that has a low interest rate and buy a currency with a higher interest rate.
Money follows yield and traders will look to take advantage of this.
Learn more about how interest rates affect forex.
HOW PPI AFFECTS THE US DOLLAR
The Producer Price Index tends to have little effect on the US dollar initially. This is because in the real economy there is a time lag between the increase in prices from producers, and the end result of higher inflation resulting from consumers having to fork out more at the tills.
However, don’t be misled by the “low priority” impact assessment of this data release. Astute traders are able to forecast the knock-on effects PPI is likely to have on CPI and interest rates and trade accordingly. Thus, the most valuable component of the PPI data is the signaling effect it provides to the market.
