Use Producer Price Index (PPI) to forecast inflation

Inflation, or the rate of change in the price of a package of goods and services, is one of the most anticipated indicators of the overall health of the economy. In healthy growth economies with appropriate monetary policies, low and stable inflation rates are most often found.

On the other hand, an uncontrolled inflation environment has significantly reduced the purchasing power of personal savings, while deflation indicates an economic slowdown. Economists and policymakers work closely with the central bank to coordinate the best open market operations and monetary policy adjustments to promote long-term stable inflation.

When inflation is high, the central bank raises interest rates to limit economic growth and the continued demand for funds. Likewise, as the government tries to stimulate the economy, periods of deflation or falling prices usually force an increase in the money supply.

For investors, inflation is an extremely useful measure because it can be used as a leading indicator for predicting the future direction of interest rates. Generally, interest rates are negatively correlated with market returns.

Key points

  • The Producer Price Index (PPI) measures inflation from the perspective of the cost of the industry or product manufacturer.
  • Because it measures price changes before they reach consumers, some people believe that it predicts inflation earlier than CPI.
  • PPI data is divided into three main classification areas, and core PPI is the most concerned.

What is the producer price index (PPI)?

Before we look at the PPI, the consumer price index (CPI) is usually the most frequently cited inflation indicator. This indicator measures the price changes of a basket of goods and services from the perspective of consumers. What is often overlooked is that the producer price index (PPI) can also be used to assess the rate of price change. According to the Bureau of Labor Statistics (BLS), a government agency that collects PPI data and publishes it monthly, PPI “measures the average change over time in the sales price that domestic producers receive for their output.”

PPI is somewhat similar to CPI. The difference is that it views price increases from the perspective of producers rather than consumers. CPI looks at the final price realized by consumers, while PPI takes a step back and determines the changes in output prices faced by producers. The difference between the two prices depends on factors such as sales taxes and price markups at all stages of the supply chain.

How to measure PPI

According to the various stages of processing, PPI has three basic measurement standards; the index can measure crude oil, intermediate products and finished products. Crude oil measured by the PPI commodity index reflects changes in the cost of input materials such as iron ore, aluminum-based waste, soybeans and wheat. The PPI stage of processing tracks the price changes of commodities in the intermediate stage of production. The index includes products such as refined sugar, leather, paper and basic chemicals.

The core PPI refers to the index of manufactured goods, which is what the average economist refers to when referring to the producer price index. Footwear, soap, tires, and furniture are all included in the core PPI.

PPI can also be subdivided into general categories of input and output measurement indicators, which reflect the rate of change in prices of consumers buying and selling their products, respectively.

When calculating the core PPI, volatile items such as energy and food prices are excluded from the core calculation. Although these omissions reduce the overall accuracy of the index, their prices are severely affected by the temporary imbalance between supply and demand, which will make long-term comparisons of the index difficult. Fortunately, BLS tracks the price changes of many of these missing components, so interested analysts can recalculate the index value to include food and energy inputs.

Once the price change is compared with the price change in 1982 as the base year of the index (value = 100), the weighted average can be used to calculate the overall value of the PPI. The weight is determined by the relative importance of each component’s share in gross national output. For example, the relative weight of plastic bottles and household lubricants is much greater than that of candles or umbrellas. The cumulative weight of the thousands of items contained in the “basket” is 100%.

In January 2011, BLS began to try to improve the processing stage index. After initially focusing only on price changes for intermediate and unprocessed products, the analysis also began to track the rising costs of service and construction activities.

Although the two measurement indicators are constructed in different ways, historically, there is a close correlation between changes in CPI and PPI.

Why PPI is important

Inflation may be the second most watched indicator after unemployment data because it helps investors infer the future direction of monetary policy. Core PPI can play multiple roles in improving investment decisions because it can serve as a leading indicator of CPI. When manufacturers face input inflation, these rising costs will be passed on to retailers and ultimately to consumers.

In addition, PPI presents inflation from a different perspective from CPI. Although changes in consumer prices are important to consumers, tracking PPI can determine the cause of changes in CPI. For example, if CPI is growing much faster than PPI, this situation may indicate that factors other than inflation may cause retailers to increase prices. However, if CPI and PPI rise simultaneously, retailers may simply try to maintain their operating margins.

Economists can also predict the future trend of the finished product index by monitoring the intermediate index, and determine the trend of the intermediate index by analyzing the crude oil index. In essence, the data obtained by monitoring downslope indicators is mainly concentrated on raw materials, which can be used to predict the core indicators of upslope. The PPI of the finished product provides a sense of expected CPI changes.

When the company encounters higher input costs, these costs will eventually be passed on to subsequent buyers in the distribution network. These companies will then charge higher prices for the final products delivered to retail locations. Although companies throughout the supply chain usually hedge their input costs, once the fixed-price contract expires, a higher price will eventually be achieved.

Bottom line

By tracking PPI trends, consumers and investors can avoid unexpected changes in inflation. Inflation is not as severe as a crash, but it can be more damaging to your investment portfolio.

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