Inflation, the rate of change in prices for a basket of goods and services, is one of the most anticipated indicators to gauge the overall health of an economy. A low and stable rate of inflation is most often found in healthy growing economies with proper monetary policies. On the other hand, runaway inflationary environments significantly reduce the purchasing power of individuals' savings, while deflation is indicative of an economic slow-down. Economists and policy makers work closely with central banks to coordinate optimal open market operations and monetary policy adjustments that promote a stable long-term rate of inflation.

When inflation is high, central banks increase interest rates in order to restrict economic growth and the continuous demand for funds. Likewise, deflation, or periods of decreasing prices, will often force an increase in the money supply as governments attempt to stimulate the economy. For investors, inflation is an extremely useful measure, since it can be used as a leading indicator to speculate on the future direction of interest rates. Typically, interest rates have a negative correlation with market returns.

What Is PPI?
The Consumer Price Index (CPI) is the most frequently cited measure of inflation. This metric measures the price change of a basket of goods and services from the perspective of the consumer. Often overlooked, the Producer Price Index (PPI) can also be utilized to assess the rate of change in prices. According the Bureau of Labor Statistics (BLS), the government body that collects PPI data and releases it on a monthly basis, the PPI "measures the average change over time in the selling prices received by domestic producers for their output."

The PPI is somewhat similar to the CPI with the exception that it looks at rising prices from the perspective of the producer rather than the consumer. While the CPI looks at final prices realized by consumers, the PPI takes one step back and determines the change in output prices faced by producers. The discrepancies between the two prices are based on factors such as sales taxes and markups as products move through the various stages of the supply chain.

How It's Measured
There are three basic measures of PPI that are based on the various stages of processing; the index can be measured on crude, intermediate and finished goods. Crude goods, measured by the PPI Commodity Index, reflects the changing costs of input materials such as iron ore, aluminum base scrap, soybeans and wheat. The PPI Stage of Processing Index tracks the price changes of goods in the intermediary stages of production. Included in this index are products such as refined sugars, leather, paper and basic chemicals. Core PPI refers to the index of finished goods and is generally what economists refer to when the producer price index is referenced. Footwear, soap, tires and furniture are among the items included in core PPI.

PPI can also be broken down into general categories of input and output measures that reflect the rate of change in prices for which consumers buy and sell their products, respectively.

When core PPI is calculated, volatile items such as energy and food prices are excluded from the core calculation. Although these omissions reduce the overall accuracy of the index, their prices are heavily influenced by temporary supply and demand imbalances that would make the index difficult to compare on a long-term basis. Luckily, the BLS tracks the price changes for many of these missing components, so interested analysts can recalculate the index values to include food and energy inputs.

Once the price changes have been compared to those faced in 1982, which serves as the base year for the index (value = 100), the overall value of the PPI is calculated using a weighted average. The weights are determined by the relative importance of the components in terms of their share of total national output. For example, plastic bottles and residential lubricants have a much greater associated weight than candles or umbrellas. The cumulative weight of the thousands of items included in the "basket" sums up to 100%.

In February 2011, the BLS began experimenting with improvements to the stage-of-processing index. After initially focusing only on the price changes of intermediate processed and unprocessed goods, the analysis began to track the escalating costs of services and construction activities as well.

Why PPI Is Important
Inflation is probably the second-most watched indicator after unemployment data, as it helps investors deduce the future direction of monetary policy. The core PPI can serve multiple roles in improving investment-making decisions because it can serve as a leading indicator for CPI. When producers are faced with input inflation, those rising costs are passed along to the retailers and eventually to the consumer.

Furthermore, PPI presents the inflation picture from a different perspective than CPI. Although changes in consumer prices are important for consumers, tracking PPI allows one to determine the cause of the changes in CPI. If, for example, CPI increases at a much faster rate than PPI, such a situation could indicate that factors other than inflation may be causing retailers to increase their prices. However, if CPI and PPI increase in tandem, retailers may be simply attempting to maintain their operating margins.

Economists can also forecast the future movement of the finished goods index by monitoring the intermediate index, and the direction of the intermediate index can be determined by analyzing the crude index. Essentially, the data obtained from monitoring the downhill indicators, those focused on raw materials, can be used to forecast the uphill core indicators. The PPI of finished goods provides a sense of the expected CPI movement. When companies experience higher input costs, those costs are ultimately passed on to the subsequent buyers in the distribution network. These firms will then charge higher prices for final products that are delivered to retail locations. Although firms throughout the supply chain will typically hedge their input costs, higher prices will eventually be realized once the fixed price contracts expire.

Almost a perfect correlation exists between CPI and PPI.

The Bottom Line
By following PPI trends, consumers and investors can avoid unexpected changes to inflation. Inflation is less dramatic than a crash, but it can be more devastating to your portfolio.

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