PRODUCER PRICE INDEX (PPI)

Markey Sensitivity: Very high.

What Is It: Measures the change in prices paid by businesses.

New Release on Internet: www.bls.gov/ppi

Home Web Address: www.bls.gov/

Release Time: 8:30 A.M. (ET); announced two weeks after the reporting month ends.

Frequency: Monthly.

Source: Bureau of Labor Statistics, Department of Labor.

Revisions: The monthly data is subject to one revision which is published four months later. Annual revisions are published in February with the January data, and it can go back five years.

WHY IS IT IMPORTANT

Inflation is public enemy number one to financial markets. It can wipe out the value of bond portfolios, depress stock prices, and push interest rates higher. So when the first major inflation number of the month comes out, a distinction that belongs to the Producer Price Index (PPI), it should come as no surprise that everyone pounces on it. The PPI measures changes in prices that manufacturers and wholesalers pay for goods during various stages of production. Any whiff of inflation here could eventually be transmitted to the retail level. After all, if business has to pay more for goods they are more likely to pass some of those higher cost on to customers. (As we’ll see later, the relationship between producers prices and consumer prices is actually not that simple.)

The producer price index is really not just one index, but a family of indexes. There are price indexes for each of the three progressive stages of production: crude goods, intermediate goods, and finished goods. The one that grab all the headlines and most excites financial markets is the last one, the PPI for finished goods. It represents the final stage of processing just before these goods are shipped to wholesalers and retailers. Prices at this last stage of production are often determined by cost pressures encountered in the crude and intermediate steps, which is why it is important to monitor all three stages.

PPI Crude Goods

The crude goods index represents the cost of raw materials entering the market for the first time. Examples of crude food supplies would be wheat, cattle, and soybeans. Non-food crude items include coal, crude petroleum, sand, and timber. Changes in the prices of these commodities are generally based on supplies, which can be subject to large swings as a result of droughts, animal disease and geopolitical factors. A spurt in prices at this early stage will be felt at the intermediate stage.

PPI Intermediate Goods

The intermediate goods index reflects the cost of commodities that have undergone transitional processing before becoming the final product. Items like flour, certain animal feeds, paper, auto parts, leather, and fabric fall into this category. Again, changes in prices here can be transferred to the final stage, which is finished goods.

PPI Finished Goods

The finished goods index is the most closely watched measure in the entire PPI report. It consists of apparel, furniture, automobiles, meats, gasoline, and fuel oil. Any inflation at this stage is considered serious because these are the products retailers pay for and thus can influence the price tag consumers will see.

Do changes in the producer prices dictate what consumer prices will do? Many economist claims there is little correlation between the two. But that conclusion is not a fair one. Much depends on which of the three main PPI indexes are chosen as a predictive tool for future consumer price inflation. During the 1970s and 1980s, shifts in the price of crude and intermediate goods often preceded changes in the CPI. However, that relationship has been less reliable since the 1990s. What has stood the test of time is the link between PPI for finished goods and the CPI. Sure, they might diverge on a month-to -month basis, but they tend to move in tandem over the longer term, usually in the range of 6 to 9 months. This complicated relationship exists because the two inflation measures have some important differences and similarities. One difference is the PPI does not take into account the price of services. In the CPI, services, like housing and medical care, make up more than half of the index. One area where both of these inflation gauges share common grounds in “consumer products”. That sector accounts for nearly 75% of the PPI for finished goods. So if prices leap higher here, chances are the CPI will also be under pressure to rise.

In addition to keeping a close eye on the PPI for finished goods, the investment community studies a subset known as core-PPI, a measure that excludes the bumpy categories of food and energy. Those two commodity groups make up a large 40% of the finished PPI, so any abnormal weather pattern or a temporary disruption in oil supplies can greatly distort the inflation numbers and mislead analysts. To get more accurate reading of the underlying inflation trend, the core-PPI- for finished goods is given equal and sometimes even greater consideration than the total index.

How Is It Computed

The producer price series began in 1902, making it the nation’s oldest inflation measure. The government computes the PPI as follows: Every month, around the week that includes the thirteenth, the Labor Department receives answers to questionnaires requesting prices on about 100,000 different items from nearly 30,000 firms around the country. A basket is formed of goods representing items at all stages of production: crude, intermediate, and finished. Which commodities are selected for the basket and what weight each has in the PPI depends on how much revenue these goods generate in the economy. The weights are reviewed and modified every five years or so to reflect changes in what industries are selling. Currently, the weights are determined based on sales patterns seen in 1997. The next change in weights will take place in 2005.

Certain categories are intentionally left out of the PPI basket. Among them are services and imported goods. Excise taxes are also not included. However, the cost of special promotional programs, such as low-interest financing and rebates, is included to the extent it reduces the price for manufacturers.

To see how prices have changed over months and years, the government establishes a baseline using an index that starts at 100 and reflects the average price of goods in 1982. So, for example, if the index for finished goods prices rises to 120, it means that inflation for the category has climbed 20% since 1982. In a deflationary environment, where prices actually decline, the index may fall from 100-90, a drop of 10%.

A breakdown of the PPI for finished goods and their relative importance is as follows:

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Finished consumer products                                                  73.34%

Finished consumer foods (20.67%)

Finished consumer goods (52.67%)

Capita equipment                                                                    26.66%

                                                                                               100%

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MARKET IMPACT

A rise in the PPI is a tough call for participants in the foreign exchange market. Normally, the dollar benefits from a little pickup in inflation since this propels U.S. short-term interest rates higher. A fast-rising inflation report, however, can hurt the dollar because the Federal Reserve can respond so aggressively as to jeopardize U.S economic growth altogether. By and large, a gradual rise in inflation that is accompanied by a well-timed tightening of monetary policy is likely to lead to an appreciation of U.S. Currency.