The Producer Price Index (PPI) of the Bureau of Labor Statistics (BLS) is a family of indexes that measure the average change over time in the prices received by domestic producers of goods and services. PPIs measure price change from the perspective of the seller. Effective with the January 2014 PPI data release in February 2014, BLS transitioned from the Stage of Processing (SOP) to the Final Demand-Intermediate Demand (FD-ID) aggregation system. The headline PPI (for Final Demand) measures price changes for goods, services, and construction sold to final demand: personal consumption, capital investment, government purchases, and exports.
Why Investors Care
The PPI measures prices at the producer level before they are passed along to final consumers. A portion of the inflation at the producer level gets passed through to the consumer price index (CPI). By tracking price pressures in the pipeline, investors can anticipate inflationary consequences in coming months.
While the CPI is the price index with the most impact in setting interest rates, the PPI provides significant information earlier in the production process. As a starting point, interest rates have an "inflation premium" and components for risk factors. A lender will want the money paid back from a loan to at least have the same purchasing power as when loaned. The interest rate at a minimum equals the inflation rate to maintain purchasing power and this generally is based on the CPI. Changes in inflation lead to changes in interest rates and, in turn, in equity prices.
The PPI comes in two key main versions: final demand (FD) and intermediate demand (ID). The final demand portion is composed of six main price indexes: final demand goods; final demand trade services; final demand transportation and warehousing services; final demand services less trade, transportation, and warehousing; final demand construction; and overall final demand.
The intermediate demand portion of the FD-ID system tracks price changes for goods, services, and construction products sold to businesses as inputs to production, excluding capital investment. There are two parallel treatments of intermediate demand, each constructed from the identical set of commodity price indexes. The first treatment organizes commodities according to commodity type, and the second organizes commodities using a stage-based, production flow model.
The PPI is considered a precursor of both consumer price inflation and profits. If the prices paid to producers increase, businesses are faced with either charging higher prices or taking a cut in profits. The ability to pass along price increases depends on the strength and competitiveness of the marketplace.
Under the prior PPI system, the producer price index was substantially more volatile than the consumer price index because the CPI included services while the PPI did not. Volatility has been reduced substantially in the PPI-FD due to the inclusion of services but the PPI still is more volatile than the CPI. Wages are a bigger share of the costs at the retail level than at the producer level and this plays a role in the CPI’s lower volatility. Also, the PPI does not include owners’ equivalent rent—a large and slow moving component in the CPI. Food and energy prices are major sources of volatility in the PPI, hence, the greater focus on the "core PPI" which excludes these two components.
The bond market rallies when the PPI decreases or posts only small increases, but bond prices fall when the PPI posts larger-than-expected gains. The equity market rallies with the bond market because low inflation promises low interest rates and is good for profits.
Producer price indexes for final demand and intermediate demand are major indicators of prices at the producer level. Changes in the producer price index are considered a leading indicator for consumer price changes.
The bond market will rally when the PPI decreases or posts only small increases, but bond prices will fall when the PPI post larger-than-expected gains. The equity market rallies with the bond market because low inflation promises low interest rates and is good for profits.
Changes in the producer price index are considered a precursor of consumer price inflation. If prices that producers receive rise, then retailers will attempt to pass those costs to consumers. However, changes in the supply and demand for labor will affect wage changes with a delay because wages are institutionalized and contractual and have a larger impact on consumer prices than producer prices.
Food and energy prices, which make up about 11 to 12 percent of the PPI-FD, are the major source of the volatility. Due to sharp movements in these two components, market players and economists have become accustomed to monitoring the PPI excluding food and energy. In shorthand, this is also referred to as the "core" PPI. (In reality, what can be more "core" than food and gasoline to consumers?)
The PPI for final demand gets the most attention, but market players have turned to the PPI for intermediate demand for early indications of inflation. This set of PPI data is organized in part by production flow. However, the earlier the stage of processing, the more volatile the index.