Summary - Every month, the Federal government releases multiple economic reports that give investors a snapshot of market conditions that could affect the stocks of individual companies or entire industries. One of the most closely watched of these economic reports is known as the Producer Price Index (PPI). This index tracks the movement in producer prices for thousands of items from commodities to finished goods. The significance of the Producer Price Index is to predict inflation. When producer prices increase, it is likely those costs will get passed along to the consumer. This is why the PPI is known as a leading economic indicator. Any movement to prices in the PPI may not be reflected in the broader economy at the time the report is issued. However, it is an indication that changes could be coming. This makes the PPI what is called a leading indicator and that is one of the ways it is different from an equally followed index the Consumer Price Index (CPI). As their names suggest, the PPI looks at price changes from the perspective of the producer while the CPI looks at price changes at the consumer level. Another difference is that where PPI is a leading (or forward-looking) indicator, CPI is a lagging indicator which means that the price changes that are noted in the CPI are already present in the economy.
The PPI covers thousands of items, however, investors generally pay attention to three headline figures that measure different stages of production. The commodity index tracks the average price change for raw materials such as coal and other commodities. The stage of production index measures price changes for goods that have been sold to manufacturers but will add value to products that are not yet at a finished level. Finally, the industry index measures price changes for goods that are in the final stage of production. The industry index, which is called the finished goods index, is what makes up the core PPI.
Investors primarily use the PPI to help gauge the rate of inflation. When investors perceive that inflation is expected to rise, it may be a sign of lower spending and potentially lower profit margins and lower stock prices. At the same time when inflation is tame, investors may perceive a higher rate of consumer spending which may spur profits and stock prices.
Introduction
Inflation is a fairly easy concept to understand. Simply put, the pricing power of the U.S. dollar is not what it used to be. So cars, houses, furniture cost more than they used to and we have to earn more money to keep up with the escalating prices. This is known as the cost of living.
But we also know that prices don't move in one direction all the time. Some of this discrepancy has to do with a metric in a business known as the cost of goods sold. This is a measurement of how much it costs a business to make a product. When investors see a company's cost of goods sold (or COGS) number increase, they will look to see if revenue is increasing as well. If it's not, it could be an indicator that the stock will be falling in the next quarter or more.
Part of a company’s COGS number is reflected in an economic report known as the Producer Price Index (PPI). The PPI, while not the definitive report on inflation, is considered a leading indicator or economic activity. In this article, we’ll provide a comprehensive look at the Producer Price Index and why understanding the strengths and weaknesses of this report can make you a better investor.
What is the Producer Price Index (PPI)?
The Producer Price Index (PPI) is a weighted index of prices from the perspective of the producer or wholesaler. The index is released once a month by the Bureau of Labor Statistics (BLS). According to the BLS, the PPI “measures the average change over time in the selling prices received by domestic producers for their output.” Prior to 1978, the index was called the Wholesale Price Index. Although the economic report is considered one index, the actual report is divided into thousands of classifications by sector and by stage in the manufacturing process. The PPI includes every physical goods-producing industry in the U.S. economy. It does not, however, include imports.
Although the PPI that is released covers thousands of items, there are three headline figures that provide a measurement for different stages of production:
- PPI Commodity Index (also called the crude index): This index tracks the average price change from the prior month for raw materials such as coal, crude oil, and other commodities.
- Stage of Production Index (also called the SOP index): This index measures any change in prices that manufacturers pay for goods that are sold to them that will add value to produce finished products. Lumber, diesel fuel, and steel are a few of the products included in this index.
- Industry Index (also called the Finished Goods index): This measures goods that are in the final stage of production. The industry index is the source that makes up the measurement known as the core PPI.
The core PPI is the number that gets the most attention. It takes the numbers from the Industry Index and removes food and energy components. This is done because those items have more volatility on a month-to-month basis. The two figures that analysts look at most closely in the PPI are the percentage change from the prior period (usually month-over-month) as well as the annual projected rate.
How is the Producer Price Index calculated?
The formula for the Producer Price Index is determined by taking the current price of a representative basket of goods and dividing it by the base price of the basket.
PPI = current price of basket/base price of the basket
With regard to PPI, the base price of the basket is set to a base year, in this case, 1982. This means that the price of materials that go into a company's finished goods is benchmarked to a 1982 standard. From this, you can see how if the cost of steel or aluminum is three times what it was in 1982, the cost that consumers pay for the finished goods that are produced by that material has increased as well.
This is known as the pass-through effect. Economists and analysts understand that when businesses experience higher costs associated with making their products, they will pass those costs along to the consumer.
However, the PPI is only a measurement of prices that producers pay during the period of the survey. If a company has a long-term contract with a customer they may have a higher or lower negotiated price that won’t be recognized until a future date.
How is the Producer Price Index (PPI) different from the Consumer Price Index (CPI)?
One way to think about the differences between the two indices is conveyed in their name. The PPI measures price trends from the point of view of the producer of the goods and services. In contrast, the CPI measures price trends from the point of view of the consumer. The PPI collects data from all levels of output: commodities in their raw state, non-finished goods that are being used in the chain of production, as well as finished goods. The CPI only measures purchases of finished goods.
This is significant because, as stated above, many of the higher costs to make a product are passed to consumers. However, that isn’t always the case. In some cases, particularly when the economy is slowing, producers may be unable or unwilling to pass along their costs.
This discrepancy points to another difference between the two indexes. The PPI is considered a leading indicator. This means it is pointing out trends or data points that are in evidence before they start to be detected in the broader economy. They are signals of what may, but not necessarily what will occur in the future. As a leading indicator, the PPI is used to help economists predict the CPI. The CPI, in contrast, is a lagging indicator which means the data that comes out of this report is already being reflected in the economy. Because the data in the CPI already exists in the economy, CPI is considered a broad measure of inflation.
The PPI is considered a weighted index because certain items are given more weight in terms of the index than others. The weighting methodology is slightly different depending on the stage of production is measured, but the intent is to ensure that the PPI is as precise as it can be based on the size and importance of a product to the overall economy.
What does the PPI tell investors?
Because the PPI is a leading indicator it doesn’t paint a definitive picture of anything happening in the economy. However, it can help investors determine how big the inflation threat may be at a given moment. Higher inflation can impact interest rates which play a significant role in a company's capital investment decisions. Likewise, low inflation can predict higher consumer demand which will lead to higher corporate profits and a higher share price.
What are the strengths of the PPI?
As stated earlier, the PPI is one of the more accurate predictors of future CPI numbers. One of the reasons for this and an added strength of the Producer Price Index is that it has proven to be adaptable over time. This gives it what is called a good “operating history” of the data. Also, the data in the monthly report is presented with and without seasonal adjustment. The PPI also provides sector-specific information that can help investors who are only looking for a specific group of companies. Finally, and perhaps the bottom line for investors is that the release of the PPI can move markets.
Does the PPI have any weaknesses?
The PPI is a snapshot of pricing activity that has not made their way into the broader economy. This doesn’t mean the PPI is inaccurate, but it means that it is only a snapshot of what may happen, not necessarily what will happen. Also, the PPI does not cover every industry and portions of the report (although not the core PPI) include elements such as energy and food which have notoriously volatile price movement.
The final word on the Producer Price Index
Among the many economic reports that investors digest every month, the Producer Price Index (PPI) is one of the most closely watched. Inflation is one of the largest threats to a company's profits and potentially it's stock price. The PPI tracks price changes in thousands of products that are used in various stages of production. The three "headline" numbers are the Commodity Index, the Stage of Production Index, and the Industry Index. The industry index (also known as the finished goods index) is what is used as a baseline for the core PPI which removes the highly volatile areas of food and energy.
PPI is one of the oldest and most reliable indicators of inflation available to investors. Prior to 1978, it was known as the Wholesale Price Index. In its current state, it uses 1982 prices as the baseline measurement. The PPI is a weighted index which means that the price movement of certain products has more of an effect on the index than others.
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