Understanding Economic Data: Producer Price Index

As yesterday's article on the U.S. current account pointed out, new information constantly becomes available to investors. Most financial commentary focuses on the impact such information has on the financial markets rather than on the information itself. In order to have a basic understanding of how the U.S. economy works and operates both domestically and internationally, you need to know how to use economic data and how to draw conclusions from analyzing the data.

Today, the Bureau of Labor Statistics (BLS) released new information about its producer price index, or PPI. The PPI rose by 0.1% in August. Although many analysts will focus on whether the PPI number will have an effect on the Federal Reserve's decision tomorrow whether or not to change the federal funds rate, the PPI provides valuable information in itself.

The basic concept
The purpose of the producer price index is to measure changes in prices that producers initially receive for goods and services. Formerly known as the wholesale price index, the PPI tends to measure prices that businesses receive for products from other businesses. This feature distinguishes the PPI from its closely related index, the consumer price index, or CPI, which tracks retail prices paid by consumers for finished products. Although the headline number for the PPI measures the prices of finished goods, the BLS also tracks prices earlier in the supply chain in its intermediate goods index (up 0.4% in August) and its crude goods index (up 2.2%).

Traditionally, the PPI focused primarily on businesses that produce goods, including mining companies like Newmont Mining (NYSE: NEM  ) , agricultural producers like Archer Daniels Midland (NYSE: ADM  ) , forestry product makers like Weyerhaeuser (NYSE: WY  ) , and heavy industrial manufacturers like Deere & Company (NYSE: DE  ) . However, over the years, the U.S. economy has developed an increasing emphasis on providing services as well as goods, and so the BLS has extended the way it calculates the PPI to include service providers. The service industries tracked by the PPI include transportation companies like FedEx (NYSE: FDX  ) , insurance providers like Aetna (NYSE: AET  ) , health-care providers, and legal and other professional services businesses.

In order to calculate PPI data, the BLS surveys over 25,000 businesses, which respond with the prices they're charging for their products. Price changes are incorporated into the overall index according to industry; various industries are assigned different weights in the index that roughly correspond to the relative value of products in that industry. For example, if the value of all shipments of a particular commodity is double the value of shipments of a different commodity, then price changes in the first commodity will have roughly twice the impact on the overall index that price changes in the second commodity have.

Because food and energy prices are especially volatile, some economists focus on what they call the core rate of the PPI. The core rate excludes food and energy prices from the index calculation. Those who focus on the core rate make an implicit assumption that food and energy prices will tend to track other prices in the long run. If this assumption is incorrect, then looking only at the core rate gives a misleading picture of price inflation at the producer level.

How the PPI affects the economy
The producer price index is used by different segments of the economy in different ways. The U.S. government, for instance, uses the PPI in calculating many other important sets of economic data, including the nation's gross domestic product. Because price inflation generally acts to increase the dollar value of economic transactions, looking only at dollar values would usually overstate the amount of growth in the economy. The government uses the PPI as a price deflator to separate the effects of price inflation from the effects of real economic growth.

In addition, many businesses use the PPI for a variety of purposes. For example, long-term contracts between businesses tend to have clauses that change the price the buyer must pay the seller for goods or services. In such contracts, businesses often use the PPI to calculate the appropriate adjustment. If a company is currently charging $10 for a product and the PPI rises 10% over a three-year period, then the contract might then call for the contract price to rise 10%, making the new product price $11.

Because the transactions tracked by the producer price index occur earlier in the product chain, many economists look at producer prices as a leading indicator of consumer prices. In other words, if producer prices rise dramatically in a short period of time, economists may conclude that consumer prices will shortly follow suit. For example, if the prices that a shoe manufacturer like Nike (NYSE: NKE  ) must pay for the rubber, fabric, and plastic used to make shoes increase, then shoe prices may need to increase in order to keep the company's profit margin stable. Whether consumer prices follow producer prices depends on the ability of retailers to pass on additional costs to consumers; if consumer demand for a product were to decrease substantially if retail prices were to rise, then a retailer may absorb higher costs rather than increasing prices to compensate.

There are several important differences in the way the PPI is calculated versus the way the consumer price index is determined. First, although the PPI has integrated some services into the index, services do not have as much weight in the PPI as they do in the CPI. Second, the PPI does not measure prices of imported products, while the CPI includes prices of both foreign and domestic goods and services in calculating the index.

Economic implications of the PPI
In general, economists look to the PPI to see evidence of price pressure at the industrial level. The PPI can act as an early warning system to alert both economists and investors of the threat of price inflation. In a way, a rising PPI is a no-win situation for the economy. If businesses pass through cost increases to consumers, then those consumers suffer a loss in their standard of living. On the other hand, if businesses choose not to increase the prices they charge to consumers, then their profits will fall and the price of their stocks may decline as a result.

In summary, the producer price index helps to give economists and investors information about the prices of goods and services early in the chain of production. This information is helpful to businesses planning capital investment and long-range strategies, government agencies tracking overall economic trends, and investors looking for clues about inflationary pressure.

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Fool contributor Dan Caplinger likes plenty of notice before he sees higher prices. He doesn't own any of the companies mentioned in this article. The Fool's disclosure policy is always easy to understand.


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