Financial Options

The latest question from a Financial Options reader is «What does it mean when the Producer Price Index [PPI] decreases?»

(Find the latest PPI figures here.)

It's important when discussing economic indicators to be precise in the terms you use and this question demonstrates why. The producer price index is exactly what its name implies, a weighted index produced by applying a formula to the prices of a basket of wholesale goods. The index directly measures the prices of goods at the wholesale level. More specifically it measures prices of goods at three stages of production - crude, intermediate and finished goods.

But you don't often hear the PPI referred to as measuring price; you hear it referred to as measuring inflation. Here's the first place where that imprecision comes into play. In fact, inflation is nothing more or less than an increase in the supply of money. Price inflation is what happens when the overall price of goods in the economy increases. If prices in general rise at the wholesale level, the PPI increases. If prices in general fall at the wholesale level, the PPI decreases.

Here's where the second bit of imprecision often happens. The simple answer to the reader's question is that when the PPI decreases all that means is that the weighted average of the wholesale prices for the goods in the index decreased. Economists would refer to this as price deflation, the opposite of inflation. The financial media often refer to the PPI as measuring inflation (in fact, I'm sure I've written that myself here), but what it actually measures is wholesale prices. Price inflation or deflation is actually the change in the PPI. The PPI itself is two places removed from actual inflation or deflation of the currency.

Of course, the reader is likely wanting more than just the simple answer «it means prices fell on average» and that's where having a bit of precision in our terminology is useful. In the bigger picture when the PPI falls, especially if it falls as part of a trend and if the fall is in the less volatile core numbers, it is one indicator that economic activity is declining. In the typical business cycle with our current monetary system, the currency inflates and prices inflate with it during times of increasing economic activity and during times of declining economic activity the rate of inflation usually falls. But, it's been typical in recent US recessions for inflation to continue, though and actual price deflation (falling prices) has been the exception. So, drops in the PPI or its retail sister the Consumer Price Index (CPI) - which represent actual drops in prices as opposed to simply decreases in the rate of increase - tend to cause a bit of alarm as they are considered serious warnings of declining economic activity. Understanding that a drop in the PPI doesn't just represent a lowering of the inflation rate (disinflation) but is actually a price deflation, and that price deflation is almost certainly correlated to a monetary deflation, helps to understand just how serious an actual sustained drop in core PPI actually is.

It is also important to consider which of the three indexes you're looking at. The goods in the Crude Goods Index are heavily affected by commodities market fluctuations, lending them to more volatility month-to-month. The Finished Goods are closest to the retail consumer and would be most likely to foreshadow changes in the CPI. While a sustained drop in any of the three would be worth paying attention, the effects could be quite different. Consider the differing effects of these two possibilities from the point of view of an investor interested in investing in a manufacturing company. In possibility one, the Crude Goods Index increases while the Finished Goods Index falls. In possibility two, the Crude Goods Index falls while the Finished Goods Index increases. In the first case, our hypothetical manufacturer probably faces declining profits as his costs increase and sales revenues fall, while in the second case exactly the opposite happens. As with everything in investing, its important to remember that nothing happens in a vacuum and the «all else equal» assumption of much of economics does not apply.

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