Why Investors Care
The PPI measures prices at the producer level before they are passed along to consumers. Since the producer price index measures prices of consumer goods and capital equipment, 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 three versions: finished goods; intermediate supplies, materials & components; and crude materials that need further processing. The finished goods PPI is most often cited in the media. This index covers final products bought from producers by businesses to sell to consumers or to use for capital equipment.
The PPI is considered a precursor of both consumer price inflation and profits. If the prices paid to manufacturers increase, businesses are faced with either charging higher prices or they taking a cut in profits. The ability to pass along price increases depends on the strength and competitiveness of the marketplace.
Producer prices are more volatile than consumer prices. The CPI includes services components - which are more stable than goods - and the PPI does not. Wages are a bigger share of the costs at the retail level than at the producer level. Commodity prices react more quickly to supply and demand. Volatility is higher earlier in the production chain. Food and energy prices are major sources of volatility, 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.
The producer price index for finished goods is a major indicator of commodity prices in the manufacturing sector. These prices are more sensitive to supply and demand pressures than the more comprehensive consumer price index. Changes in the producer price index are considered a leading indicator for consumer price changes, although only a small portion of the PPI is directly connected to less than half of the CPI.
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 for finished goods are considered a precursor of consumer price inflation. If the prices that manufacturers pay for their raw materials rise, they would have to raise the prices that consumers pay for their finished goods in order to not decrease profit margins. Changes in the supply and demand for labor will affect wage changes with a delay because wages are institutionalized and contractual. However, commodity prices react more quickly to changes in supply and demand.
Commodity prices vary from month to month, but food and energy prices, which make up nearly one-quarter of the PPI, 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 finished goods gets the most attention, but market players have turned to the PPI for intermediate materials and crude materials for early indications of inflation. The earlier the stage of processing, the more volatile the index.