Understanding The Producer Price Index And Consumer Price Index As An Investor

Key Takeaways

• The PPI measures the change in selling prices received by domestic vendors and represents the cost of producing goods.
• The CPI measures the change in prices consumers pay for everyday items.
• Both reports influence the Federal Reserve when deciding whether to raise, lower, or hold interest rates.

The Producer Price Index and Consumer Price Index are two key indicators of the U.S. economy. In fact, one could make the case, these are the two most important reports released by the Bureau of Labor Statistics. Here is an explanation of how these indexes work, impact economic policy, and influence investors.

What is the Producer Price Index?

The Producer Price Index (PPI) is a program overseen and published by the US Bureau of Labor Statistics (BLS). It tracks the wholesale selling prices that domestic manufacturers receive for their products and services. The prices collected represent the initial cost of a product or service as it reaches the market and tracks current pricing for around 10,000 products and services. This includes industries such as natural gas, agriculture, manufacturing, construction, retail, real estate, healthcare, and more. The primary purpose of the PPI is to measure the change in prices producers receive for their goods and services.

The PPI uses samples from over 25,000 commercial entities that provide about 100,000 price quotations monthly. The businesses participate voluntarily in the program and are selected for the PPI by systematic sampling. The PPI undergoes regular resampling as market conditions and industries change.

How information from the PPI is used

Producers use the information collected from the PPI in various ways. Data from the PPI can be used for:

• Forecasting
• Last-in, first-out inventory valuation
• Contract adjustments
• Tracking overall price movements
• Adjusting economic deflators
• Measure of price movements for specific industries and products
• Compare input and output costs

Various industries use the data delivered by the PPI to make decisions that affect their operations at all levels. The PPI can be used for forecasting sales of a product for a specific period, determining if the product can weather a price increase, and predicting if raw materials are going to become more or less expensive.

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What is the Consumer Price Index?

The Bureau of Labor Statistics also produces the Consumer Price Index (CPI), which measures the average price of a basket of consumer goods and services domestic producers provide. CPI data is collected directly from 24,000 consumers and the selection of a specific item from a given category. For example, the report might look at the cost of a gallon of skim milk. Consumers selected for the survey keep a journal of their purchases for two weeks and submit their data to the BLS at regular intervals. Quarterly interviews with 48,000 consumers supplement the data. The information helps determine the importance of item categories in the index.

The CPI is used to track inflation for the average consumer. It gets its data through sampling and self-reported consumer price tracking. Data is collected from across the US, allowing the report to capture data from people who live in rural and urban areas, people who are employed and self-employed, poor and wealthy alike.

How a sample for the CPI is created

The CPI has over 200 categories in eight major groups (food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services). Each category in the index is put through an initiation process. The initiation process involves a CPI data collector picking a specific item from a category and pricing it. The item is selected based on its perceived popularity, and its price is entered into the category.

For example, imagine a grocery store that carries a popular type of deli meat. It’s sold in eight-ounce packages and makes up 90% of all sales of that type of meat, with smaller packages accounting for the remaining 10%. It’s a reasonable conclusion that the eight-ounce size is nine times more likely to be chosen over all other sizes. The meat in the eight-ounce size will then enter the category and be re-priced every month or every other month for four years.

The collected information is part of the overall calculation for the given category that goes into the basket of consumer goods. All 200 categories are then calculated to achieve the final number for the CPI.

How these reports influence economic policy

The PPI and CPI play a role in various economic decisions and policies the federal government sets. The PPI is viewed as a leading indicator of inflation as rising costs at the wholesale level result in consumers paying more at the retail level. When central banks see a significant increase in PPI, they tend to respond by increasing interest rates. If the PPI number indicates a deflationary economy, central banks can respond by lowering interest rates. Lower interest rates result in more cash flowing into the economy, while higher interest rates reduce the amount of money people spend and borrow.

The CPI has more influence on economic decisions due to its impact on consumers. It’s a lagging indicator of inflation, but it’s also seen as an indicator of a particular government policy’s efficacy. It’s used to deflate the dollar’s value and adjust benefits, like Social Security, to keep pace with cost of living increases. This affects military salaries, people who receive food stamps, Federal Civil Service retirees, children who eat school lunches, and can affect the Federal income tax structure.

How These Reports Influence Investors

If either the PPI or CPI rises, it signifies that daily life has become more expensive – inflation. Since the Federal Reserve has a target range for inflation, 2-3%, any movement above this range can force the Fed to raise interest rates. When this happens, the stock market will likely come down as business growth slows, and fewer consumers will invest because more of their money is going towards the increase in the cost of living.

If the PPI or CPI falls and inflation goes below the target range, the Fed may lower interest rates to encourage spending. This can lead to a boom in the stock market, as low borrowing costs encourage businesses and consumers to spend. The result of more spending is higher corporate earnings and higher stock prices.

Where PPI and CPI stand today

In September 2022, the PPI for final demand for goods and services increased by 0.4%. It increased by 8.5% for the 12 months beginning in September 2021 and ending in September 2022.

The CPI also increased 0.4% in September 2022 and rose 8.2% in the all items index for the 12-month period that ended in September 2022. The increase in the CPI was caused by the rising costs of shelter and food but tempered by the drop in gasoline prices.

Bottom Line

Both the PPI and CPI reports are essential for economists and investors alike. They help bring the blurry picture of the U.S. economy into focus so that decisions can be made to keep us running at peak performance. However, as we have recently seen, sometimes inflation is so strong and quick that even a small delay in raising interest rates can have an outsized impact on the economy and the stock market. All that investors can do in this situation is pay attention to other economic indicators and take a more defensive stand with their investment portfolio.

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