PPI Hotter Than Expected - Analyst Blog

The Producer Price Index (PPI) for finished goods rose at a much higher than expected rate of 0.8% in November on a headline basis. The consensus had been looking for a 0.5% increase. This was due to higher food, and especially energy prices.

Stripping out the volatile food and energy prices, the core PPI rose 0.3%, just slightly above expectations of a 0.2% increase. That came on the heels of a 0.6% drop in core prices in October. In September, headline prices also rose 0.4%. Core inflation was 0.1% in September.

Relative to a year ago, headline PPI is up 3.5% from a year ago, and the core PPI is up 1.2%. Most of the price increase for the month came from energy, which jumped 2.1%. That is not quite as bad as the 3.7% rise in October, but it does come on top of it. Food prices were up 1.0%, but that comes on the heels of a 0.1% decrease in September. Year over year, food prices are up 4.0% and energy prices have risen 9.6%.

While everyone uses both food and energy, the Fed pays more attention to core prices in setting monetary policy. If the Fed we following the headline numbers, they would have been tightening monetary policy sharply in the first half of 2008, when we were already in a recession, but did not officially know it. But such a move would have made the financial collapse much worse.

QE2 Decision Vindicated

Core prices are falling at an annualized rate of 0.8% over the last three months, which seems to vindicate the Fed's decision to launch the 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 crude 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 November, intermediate goods prices were up 1.1%,  after an increase of 1.2% in October. On a year-over-year basis they are up a somewhat worrisome 6.3%.

Stripping out food and energy from the intermediate level, prices were up 0.7% in November after rising 0.6% in October. While the year-over-year change is a bit on the hot side at 4.7%, the recent trend is a bit worrisome, on both a headline and a core basis if those increases start to filter into finished goods prices.

Crude goods, which are essentially commodities, are extremely volatile; they rose just 0.6% in November, but that was after rising 4.3% in October. Still, they are up 12.8% 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.

Verdict: Negative, but Not Awful

I consider this to be a somewhat negative, but not awful, report. On the plus side, the threat of deflation now seems squarely off the table. 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.

On the negative side, it means that there is a real chance that inflation will start to crop up at the consumer level (we will see about that tomorrow when the CPI comes out). We are already seeing some of that inflation at the gas pump as prices flirt with $3 per gallon nationwide, and that reduces what people can spend elsewhere in the economy.

I still see the slow economy and high unemployment as a much more serious problem than inflation, but if we do start to get significant bleed through of higher producer prices, especially at the core level into consumer prices, the Fed's room to maneuver will be significantly reduced. The year-over-year rise in finished core prices is not yet a problem at 1.2% on a finished level, but the 4.7% increase at the intermediate level is troublesome. 

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. The recent deal, now working its way through Congress should provide at least some fiscal stimulus, most importantly through the cut in the payroll tax and the extension of unemployment benefits.

However, the extension of unemployment benefits, and the extension of the high income Bush tax cuts (well, actually all of the Bush tax cuts) is the prevention of fiscal contraction rather than the net addition of new fiscal stimulus. Still, relative to the “let them all expire” option it should result in a stronger economy. However, it comes at the cost of a very big increase in the deficit over the next two years.
 
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