In this article, we will look at the US producer price index, also called the PPI (Producer Price Index). We will discuss how it is calculated, what it is and how it can be traded.
The Producer Price Index is an economic report that reflects the change in the cost of products sold by various manufacturers and industries. As such, it is a measure of inflation and is closely watched by most traders and investors.
Fundamental traders use the PPI index to measure the rise in inflation for a particular currency pair. Day traders also watch this index as it can generate the volatile price movements needed to look for short-term trading opportunities.
What does the producer price index show?
Producer price index data is compiled by the US Bureau of Labor Statistics. The PPI economic report is published every second week of the month. The Bureau of Statistics also publishes percentage changes in the index. These changes are related to prices for goods and services of producers. Therefore, the index shows the change in price from the point of view of the seller, not the buyer.
Producer price indices exist for virtually any sector of industry or commodity. In fact, the Bureau publishes about 10,000 indices, ranging from individual products to product groups. Various indexes are available for mining, manufacturing, fisheries, forestry, agriculture, natural gas, electricity, construction, etc.
How is the PPI calculated?
The calculation includes index data that compares the current price with the price of the base period. Different goods and products are calculated according to their size and importance, which is intended to improve the accuracy of the PPI index.
Building an index goes through various steps. The Bureau primarily uses economic census data from the Census Bureau to assess the importance of products, and these values change every 5 years.
The producer price index was originally called the wholesale price index from its inception in 1902 until 1978. The Bureau has moved from a single index covering the entire economy to a system of three main indices. The new indices took into account the various stages of production (SOP) and minimized the risk of double counting.
In February 2014, the Bureau changed the focus of the indices from final demand to intermediate demand (FD - ID). At the same time, prices and the share of various products and goods, construction, government purchases and exports began to be included as well.
What exactly is included in the index?
The Bureau publishes a variety of indexes and percentage changes that reflect percentage changes every month, year after year, as well as seasonally adjusted data.
The published indexes are grouped into three main classifications:
- Industry classification (Industry Classification) has about 535 indices.
- The Commodity Classification covers approximately 3,700 different single commodity indices.
- Intermediate Demand Classification (Commodity-Based Final Demand - Intermediate Demand Classification) publishes more than 600 different indices that measure price changes on a monthly, annual and seasonal basis.
This all sounds extremely complicated at first glance, but the forex market primarily takes into account only the percentage change in intermediate demand for monthly and yearly changes, excluding food and energy.
An index that excludes food, energy and services is needed because food and energy tend to be much more volatile components of the index. This is due to the correlation of these components with raw material prices, which can fluctuate by several percent on a monthly basis.
Most traders will look at the underlying PPI as this number is likely to reflect the underlying trend in inflation expectations.
Annual PPI data is often mentioned by politicians when talking about the state of inflation in the economy.
Publications of data can be seen in any economic calendar in real time. However, you can also obtain some data directly from the US Bureau of Labor Statistics website (https://www.bls.gov).
How is PPI data collected?
Various companies are selected and invited to participate in the survey. As soon as a certain company agrees to take part in the survey, the economist contacts it to arrange the delivery of information through the questionnaire. Data is collected monthly, typically on Tuesdays of each week. The bureau receives approximately 25,000 price reports for approximately 100,000 items.
If the firm does not send or sends incomplete information, the economist contacts the firm again to obtain the necessary data. Firms continue to submit reports until a new model is chosen for their industry. This happens on average every 7-8 years.
Why should traders consider the Producer Price Index?
The nature of the index data acts as one of the indicators of inflation. Percentage changes measure the rise and fall in the prices of goods and services by producers themselves. Higher prices usually lead to higher inflation.
The PPI index measures the prices of goods at the producer level just before they are delivered to the final consumer. Tracking these price levels helps traders gauge future inflationary pressures. Indices serve as a precursor to inflation data and are also used by the government and the Federal Reserve to guide fiscal and monetary policy.
A consistent and sustained increase in the PPI index will inevitably lead to an increase in the consumer price index and inflation readings. Inflationary pressure forces the Fed to periodically review its position on interest rates and may even lead to a rate increase. Likewise, a decline in PPI change should lead to lower inflation and is a reason for more dovish action by the Fed.
Higher producer prices also mean that companies should aim to increase profits. This is positive for the economy and good for the stock market if this trend is within the normal range.
Initially, higher inflation leads to higher interest rates, which is always good for a currency. Investors will show a stronger preference to hold securities in a currency with a higher yield, all other things being equal.
Higher PPI growth rates usually indicate a more favorable environment for sellers and a buoyant economy. Economic growth will also be a factor in currency appreciation, so even if the change in the index is domestic or within the Fed's target, it can be seen as positive for the dollar as it indicates the economy could still be in very good shape.
The graph above shows the monthly annual percentage change in the Producer Price Index in the US EU over the past 10 years. We can see that during the whole period the US index outperformed the EU PPI.
Note that apart from the initial period on the chart, which continued until the end of 2008, the US producer price index was still higher than in the EU, however, the euro appreciated against the US dollar. This was due to the mechanisms of investor behavior in connection with the housing crisis and financial turmoil that arose at that time in the United States.
The last part of the chart above shows how EU PPI changes outpaced US PPI changes over several months from January 2017 to June 2017.
When we look at the EURUSD price chart for the same period, we see a growing bearish trend. The policies of the ECB and the Fed also influenced the market in terms of monetary policy.
Another period that stands out on the chart is the time period from mid-2013 to the end of 2016. During this period, the US PPI consistently outperforms the EU PPI. If we look at the EURUSD price chart for the same period, we can see how the euro continues to fall against the US dollar throughout this phase.
How to trade the Producer Price Index?
As with any type of economic data, it is essential to have a clear understanding of how the release of this report could affect the market. This can be done by looking at expectations for the PPI report as well as comparing analyst forecasts published on various websites.
The US PPI is a predictor of inflation, so its reports are important to get a general idea of the fundamentals. However, this should be confirmed by the next PPI report as well as the next inflation report. This means that, more often than not, this data release will create price volatility in the short term only when the current report is very different from the expected one.
However, when the Producer Price Index rises, it causes the US dollar to rise in price against currencies, in particular, which are declining inflation. This is because interest rates move in opposite directions.
An example of how volatile the index can be was the unexpectedly high percentage change on September 14, 2012. The monthly PPI rose 1.7%, beating economists' forecasts by 0.5%. The rise was the highest since June 2009 and gave the US dollar a strong boost. EURUSD rose 1.1% or 143 points, while USDJPY rose 0.96% or 74 points. September 14 also marked the day USDJPY turned a recent bearish trend into a bullish one. The price rose from that day's close of 77.29 to an instant high of 103.74 in May 2013.
In the event that the data significantly exceeds expectations, this could lead to a significant increase in volatility. In some cases, as in the example above, it can also be a catalyst for major economic trends and inflation.
Summing up
We've looked at what the US Producer Price Index is, what it measures, and why it's important to traders. For fundamental traders, this index is an indicator of inflation as well as economic health, since higher prices lead to a greater likelihood of increasing company earnings.
Changes in inflation lead to changes in monetary policy. Therefore, significant changes in this index are a telling sign of what to expect from the Federal Reserve, especially when the PPI data is confirmed by the CPI inflation data.