How to Use the PPI in Forex Trading

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).

The Producer Price Index (PPI) is an important economic data point 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. Ultimately, however, traders are concerned with how the resulting interest rate changes are likely to affect currency pairs. Read on to learn more about the PPI index and how it impacts the foreign exchange market.

What is PPI?

PPI stands for Producer Price Index and measures the change in the prices 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 ultimately, price increases get passed down to consumers. If this effect is large enough, there will be an increase in future CPI (Consumer Price Index) 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 beneficial for an economy, but only when it is contained. When demand for goods and services increases, businesses must increase capital expenditure and hire more workers to increase 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. For example, $1 can buy less than it could one year ago.

In the 1950s, gasoline was $0.27, apartment rent was $42/month, and a movie ticket was $0.48. These figures are significantly lower than today’s prices, reflecting how inflation erodes the value of local currency. Central banks attempt to combat the erosion of purchasing power by raising the benchmark interest rate.

How Does PPI Impact Currencies?

There is always a trade-off when it comes to money – individuals can save money and earn interest, or they can spend money immediately and forgo any interest payments.

If PPI (Producer Price Index) is rising, it may cause interest rates to rise. When interest rates go up, saving money becomes 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 instead of saving. As a result, increased PPI may filter down into higher interest rates and a stronger currency.

Using the Euro as an example, forex traders know that higher interest rates result in increased financial flows from foreign investors wanting to buy the higher-yielding Euro. This effect tends to drive the value of the Euro up as demand for the currency increases.

A popular strategy to take advantage of higher interest rates is the “carry trade” strategy, where traders borrow funds in a currency with a low interest rate and buy a currency with a higher interest rate.

Money follows yield, and traders will look to capitalize on this.

How PPI Affects the US Dollar

The Producer Price Index tends to have little initial effect on the US dollar. This is because in the real economy, there is a time lag between the increase in prices from producers and the resulting higher inflation as consumers have to pay more.

However, savvy traders can forecast the knock-on effects that PPI is likely to have on CPI (Consumer Price Index) and interest rates, and trade accordingly. Therefore, the most valuable component of the PPI data is the signaling effect it provides to the market.

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