Producer Prices Fall, But is Inflation Lurking Behind the Headlines?

The Dow Jones Industrials (DJINDICES: ^DJI  ) is trying to avoid closing out the week with five straight losses. The average managed to post a seven-point gain as of 12:30 p.m. EDT, after dropping in morning trading. Most investors focused on the conflict between Russia and Ukraine in explaining the decline, largely ignoring a benign report on inflation at the wholesale level. But behind the headline number of a 0.1% drop in the Producer Price Index for February, you can find at least signs of inflation that could lead some Dow stocks to outperform others.

The battle between goods and services
At a glance, this morning's PPI report showed few hints that inflation is any concern whatsoever. With February's decline, the 12-month rise in the index was just 0.9%, down by more than half from the 2% year-over-year gain it posted in July 2013. Although the Federal Reserve's 2% inflation target applies to prices at the consumer level, PPI gains at less than half that target suggest that wholesale inflation is well in check.

But the new methodology that the Bureau of Labor Statistics now uses indicates a disparity over the past few months between rising prices of goods versus falling prices of services. Since December, the final-demand goods component of the PPI has increased 0.4% in three straight months, rising at a nearly 5% annual pace. By contrast, prices for final-demand services have fallen in two of those three months and are down slightly for the three-month period.

Moreover, looking at the intermediate-demand data series, which reflects an earlier stage in the production process, you'll find a further distinction between processed and unprocessed goods. Over the past 12 months, processed-goods prices are unchanged, but unprocessed goods have seen a 5.4% price increase. More than half of that increase came from natural gas prices, which soared 31.5% due to the tough winter and its impact on utility demand.

Will inflation trickle down to consumers?
The reason why paying attention to producer prices is so important is that in many cases, they filter through to consumer prices. But that process can take a long time. For instance, specifically with respect to natural gas prices, gas utilities often have to suffer short-term losses from unexpected price spikes, only later going back to regulators to request higher rates for their customers. That has already started happening, with National Grid (NYSE: NGG  ) requesting a 16% rate hike for natural-gas service in Rhode Island. Even that request is extraordinary in that the utility is asking for it to take effect in April, in the middle of its typical November-to-October pricing year. Similarly, PG&E (NYSE: PCG  ) could end up needing to augment a previous 12% rate-hike request, which was tied to pipeline repairs rather than specifically earmarked for rising gas prices. Canada is dealing with the same problems, as gas utility Enbridge (NYSE: ENB  ) recently asked for a whopping 40% natural-gas price increase to reflect the price spike.

Energy costs are front and center in consumers' minds right now, but it's also important to note that core-goods PPI figures have also seen a slight uptick. This suggests a new trend might be emerging that could reward companies that produce goods over those that provide services. Given the struggling labor market, that shouldn't come as a huge surprise. But it means stocks of certain commodity producers that have been beaten down for a long time could finally stage a comeback in the months ahead, as long as the trends we've seen this winter carry through even after the weather improves.

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