The Producer Price Index (PPI) for finished goods rose at a higher than expected rate of 0.4% in August on a headline basis. The consensus had been looking for a 0.2% increase. Stripping out the volatile food and energy prices, the core PPI rose just 0.1%, in line with expectations.
In August, headline prices also rose 0.4%. Core inflation was 0.1% in August and 0.3% in July. Relative to a year ago, headline PPI is up 4.0% from a year ago, and the core PPI is up 2.2%. Most of the price increase for the month came from food which jumped 1.2%. Energy prices were up 0.5%, but that comes on the heels of a 2.2% increase in August. 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” of not too hot and not too cold. The September 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.
Up the Production Chain
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 August, intermediate goods prices were up 0.5%, and that was after an increase of 0.3%, but a decline of 0.4% in July.
However, on a year-over-year basis they are up a somewhat worrisome 5.6%. Stripping out food and energy from the intermediate level, prices were up 0.2% in September after rising just 0.1% in August, but after falling 0.4% in both July and June. While the year-over-year change is a bit on the hot side at 4.0%, 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 they dipped a bit in September, falling 0.5%. However, 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 20.3% 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. In recent weeks, commodity prices have been very strong, so it is likely that crude goods prices will jump when the October numbers come out.
News Is Just OK
Even though the headline number came in higher than expected, and was double the July level, overall I consider this to be an OK 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.
Given the enormous amount of slack in the economy, I still think that engaging in some quantitative easing would help, although 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).
The current numbers do help assuage some of the fears that we might be headed into outright deflation. Outright deflation is just about the only scenario under which owning long-term treasuries makes sense at current rates.
Thus I suspect that these numbers will be bad news for the bond market, but they are not so high as to be a negative to the stock market. A good way to play rising longer term interest rates is through some of the short bond ETF’s such as TBT.