Core PPI Lower than Expected - Analyst Blog

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for finished goods rose at a much lower than expected rate of 0.4% in October on a headline basis. The consensus had been looking for a 0.8% increase.

Stripping out the volatile food and energy prices, the core PPI dropped 0.6%, far below expectations of a 0.1% increase. In September, headline prices also rose 0.4%. Core inflation was 0.1% in September and August.

Relative to a year ago, headline PPI is up 4.3% from a year ago, and the core PPI is up 1.5%. Most of the price increase for the month came from energy, which jumped 3.7%, and acceleration from the 0.5% rise in September. Food prices were down 0.1%, but that comes on the heels of a 1.2% increase in September. Year over year, food prices are up 3.6% and energy prices have risen 13.2%.

The sharp drop in the core PPI this month seems to vindicate the Fed's decision to embark on another round of quantitative easing (QE2). The principal danger in QE2 is that it would set off runaway inflation, but there seems to be little danger of that right now, especially outside of commodities.

While commodity prices have been up sharply over the last year, they tend to make up a very small part of a consumers shopping cart. Yes, you buy bread, which is made up of wheat, but the actual cost of the wheat in the bread is less than 5% of the cost of the loaf.

If one looks a bit further up the production chain at intermediate and cured goods (think Bread, Flour, 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 October, intermediate goods prices were up 1.2%, after an increase of 0.5% in September. However, on a year-over-year basis they are up a somewhat worrisome 6.4%.

Stripping out food and energy from the intermediate level, prices were up 0.6% in October after rising just 0.2% in September. While the year-over-year change is a bit on the hot side at 4.4%, 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 rose 4.3% in October. But that was after falling 0.5% in September. Still, they are up 17.0% year over year, though commodities prices were still fairly depressed a year ago. They are something to keep an eye on, but as previously mentioned, commodities make up just a small fraction of the value that eventually finds its way into final goods.

I consider this to be an good report. The drop in core prices might set off alarm bells about the potential for deflation, but QE2 should take care of that going forward.

At the headline level prices are still a little on the hot side, mostly reflecting higher energy prices, which have as much to do with how fast China is growing as what is happening here. Deflation does not seem likely at the headline level anytime soon.

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.

Given the enormous amount of slack in the economy, I still think that QE2 will help. This report would seem to support that position.

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. Unfortunately, the new Congress is going to be taking us in exactly the wrong direction and is likely to impose austerity in spending.

And they want to couple that with the least effective form of stimulus around -- an extension of the Bush tax cuts for the very wealthy. Those tax cuts have been in place for ten years, and have not proved to be very helpful in growing the economy or jobs, so why should we expect them to suddenly help right now?

In the absence of fiscal stimulus, or in the face of actual fiscal de-stimulus (there is a lot of that happening at the State and Local government level, but they don't have much of a choice; they are not allowed to run deficits for operating budgets) monetary stimulus is the only game in town.  The potential danger of using monetary stimulus is the potential for setting off inflation, but judging by the behavior of core prices, that seems a very remote threat right now.

The graph below shows that core inflation is relatively low by any historical standard on a year-over-year basis. It also shows how much more volatile headline inflation is than core inflation, which is the main reason why the Fed looks at core prices more closely than they do at headline prices.

QE2 will help a little bit, but is not a magic bullet in terms of getting the economy rolling again. That said, it is a very effective tool in preventing outright deflation.