Producer Price Index Up 0.4% - Analyst Blog

The Producer Price Index (PPI) for finished goods rose at a slightly higher-than-expected rate of 0.4% in August on a headline basis. The consensus had been looking for a 0.3% increase. Stripping out the volatile food and energy prices, the core PPI rose just 0.1%, in line with expectations.

In July, headline prices rose 0.2%, but in June they fell 0.5%. Core inflation was 0.3% in July and 0.1% in June. Relative to a year ago, headline PPI is up 3.1%, and the core PPI is up 1.9%.

Most of the price increase for the month came from energy, which jumped 2.2%. However, that comes on the heels of four straight months of declining energy prices at the wholesale level. Thus it does not look like energy prices are spiraling out of control. Food prices fell 0.3% in August after a rise of 0.7% in July and a 2.2% decline in June.

The current levels of PPI inflation are sort of in the "Goldilocks" zone -- not too hot, not too cold. The August numbers indicate that the threat of deflation is receding, but they also show no real signs of a dangerous acceleration in inflation, particularly at the core level.

Beneath the Headline Numbers

If one looks a bit further up the production chain at intermediate and cured goods (think Bread, Flour and Wheat to keep finished, intermediate and crude goods separate in your mind), there is a bit more inflation pressure. The further up the production chain one goes, the more volatile prices become.

In August, intermediate goods prices were up 0.3%, but that was after declines of 0.4% in July and 0.9% in June. However, on a year-over-year basis they are up a somewhat worrisome 5.0%. Stripping out food and energy from the intermediate level, prices were up 0.1% in August after declining 0.4% in both July and June. While the year-over-year change is a bit on the hot side at 4.2%, the recent trend is far from alarming, either on a headline or a core basis.

Crude goods, which are essentially commodities, are extremely volatile, and have been headed higher. In August they rose 2.3% after a 2.7% rise in July, but that was after a 2.4% decline in June. Still, they are up 18.3% year over year, but commodities prices were still fairly depressed a year ago. They are something to keep an eye on, but commodities make up just a small fraction of the value that eventually finds its way into final goods.

Analysis: Good Report

Even though the headline number came in a tick higher than expected, and was double the July level, overall I consider this to be a good report. At the core level prices are very well behaved, and the report helps quell the very real fears that the economy might be heading into a Japanese-style deflationary scenario.

At any given level, deflation is far more destructive to the economy than an equivalent level of inflation. Deflation raises real interest rates, and that stops business investment. At the same time, if consumers think that goods are going to be cheaper in the future than they are today, they will simply sit on their wallets and wait. The resulting slowdown in demand further slows the economy, and forces more people out of work.

Since the Fed has already cut short-term rates to zero, they have very limited flexibility in dealing with the situation. Quantitative easing -- the buying up of long-term T-notes to expand the money supply -- can help in such a situation. However, policy makers do not have a lot of experience in dealing with this situation, so it is hard for them to gauge just how much quantitative easing is enough, and how much is too much.

While given the enormous amount of slack in the economy I still think that engaging in some quantitative easing would help, this report would seem to indicate that the effort might be more modest. When we are up against the zero bound with interest rates, fiscal stimulus is much more effective than monetary stimulus in getting the economy moving again. That is not always the case: in a garden-variety downturn, policymakers should first turn to monetary policy.

Aside from the unconventional methods like quantitative easing, the Fed has spent its ammo a long time ago (and it is a good thing that it acted as quickly and as decisively as it did; if anything, they should have been more aggressive earlier).

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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