Disinflationary Trend Remains Intact

The Producer Price Index was released this morning by the Bureau of Labor Statistics [BLS]. The Producer Price Index [PPI] program measures the average change over time in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services.

The PPI report is one of the best inflation reports and tends to be much more leading than the Consumer Price Index report. 

There are thousands of sub-components to the PPI report divided into various groupings including the type of commodity and stage of production. In this report, we will take a look at the more cyclical components of the PPI release and discuss some of the cyclical drivers of inflationary pressure. 

Although growth cycles and inflation cycles are different and at times unsynchronized, we currently find ourselves in an economic regime of decelerations in growth and inflation as we will see below. 

The headline PPI index has been decelerating for nearly a year, falling to a multi-month low of 1.81% year over year. 

Much like growth, inflationary pressures move in cycles. When measuring growth or inflation, we should be watching the cyclical movements and the early indicators that the cycle is going to inflect higher or lower. These cyclical changes in direction are not sudden or rapid most often but as their name describes; cyclical. 

Producer Price Index Year over Year (%):Source: BLS, EPB Macro Research 

Core PPI, which removes categories such as food and energy is also starting to decelerate, falling to 2.26% year over year but in a much less pronounced fashion relative to the headline index. While the core index has yet to stage a pronounced deceleration to convince many inflation hawks, below we will look at the cyclical components to the PPI report that lead the core PPI index and conclude by discussing some of the cyclical drivers of broad inflationary moves. 

Core Producer Price Index Year over Year (%):Source: BLS, EPB Macro Research

As mentioned, the PPI report can be divided in many ways. First, we will look at the differences in goods, services, and construction prices, each varying in their cyclicality. 

Unsurprisingly, goods inflation is the most cyclical and has decelerated from 4.4% to 0.6% over the past several months. Services inflation, looking much like core PPI, has slightly come off the recent high and construction inflation sits at a multi-year high. 

Producer Price Index Breakdown: Final Demand Year over Year (%):Source: BLS, EPB Macro Research

Why does the decline in goods inflation lead other categories of inflation? Below is a quote from a 1941 paper on leading indicators authored by Wesley Mitchell: 

While the price level is often sagging slowly when a revival begins, the cumulative expansion in the physical volume of trade presently stops the fall and starts a rise [p. 151]. Like the increase in the physical volume of business, the rise in prices spreads rapidly; for every advance of quotations puts pressure upon someone to recoup himself by making a compensatory advance in the prices of what he has to sell. . . . Retail prices lag behind wholesale . . . and the prices of finished products [lag] behind the prices of their raw materials [p. 152].

Among the threatening stresses that gradually accumulate within the system of business during seasons of high prosperity is the slow but sure increase in the costs of doing business [p. 29]. The price of labor rises. . .. The prices of raw materials continue to rise faster on the average than the selling prices of products [p. 154]. [T]he advance of selling prices cannot be continued indefinitely . . . [because] the advance in the price level would ultimately be checked by the inadequacy of the quantity of money [p. 54].

This description articulates the sequence of events that typically ensues during a cyclical rise in inflation. This is why it is critical, when measuring growth or inflation, to look at the sequence of economic decelerations/accelerations rather than focusing on any single data point. 

If you understand the sequence, while most analysts will attribute a sudden fall in an index to "statistical error" or a "one-off" those that understand the sequence will be less surprised by this change in direction; they will even anticipate it. 

If we look at the breakdown between finished goods and intermediate goods, we can see that intermediate goods are already in a deflationary trend, falling 0.64% relative to one year ago. 

Producer Price Index Breakdown: Stages Year over Year (%):Source: BLS, EPB Macro Research

One of the channels by which an inflationary cycle can emerge is through commodity pressure. Commodity inflation, defined by the "All Commodities" index in the PPI report is also in deflation, falling 0.84% compared to a year earlier. 

Producer Price Index: All Commodities Year over Year (%):Source: BLS, EPB Macro Research

If we break down the commodity index into industrial commodities, we can look at industrial commodities and industrial chemicals, two indicators that are very sensitive to inflationary pressure coming from the commodity channel; one of four main inflationary channels. 

Both measures of industrial commodities are in deflation.

Producer Price Index: Commodities: Industrials Year over Year (%):Source: BLS, EPB Macro Research

One of the larger drivers of the commodity channel is crude oil. While crude oil did not bottom until February 2016, the year over year change in the PPI crude petroleum index had already bottomed. Currently, the crude petroleum index, in year over year terms, has not put in a bottom which casts more doubt that an inflationary cycle will emerge from the commodity channel in the coming quarters. 

Producer Price Index: Commodities: Crude Petroleum Year over Year (%):Source: BLS, EPB Macro Research

The PPI report holds great information as it pertains to leading indicators of cyclical shifts in inflation, mainly via the commodity channel. 

When looking for a cyclical shift in inflationary pressure, most often, four channels will cover the inflationary impulse in the economy. Creating a leading indicator of inflation covers all four of these channels: money, credit, currencies, and commodities. 

In the coming weeks, I will dive into each category in more detail. To summarize briefly, we are not seeing inflationary pressure emerge from any of the four channels and in fact, most are pointing lower which suggests that inflationary expectations will continue to trend lower. 

The US Dollar is near an all-time high against a broad basket of currencies and money supply growth continues to decelerate. Commodity pressure is moving into a deflationary trend as outlined above and the credit impulse from tax cuts and large deficit spending is shifting negative on a second derivative basis. 

It should be noted that a low unemployment rate or a "tight" labor market was not cited as an inflationary channel as this relationship has been debunked over time. Those waiting for inflation to spike due to the low unemployment rate should study the current situation in Japan. An unemployment rate of 2.40% with an inflation rate of 0.90%. Japan had an unemployment rate as low as 2.2% in recent months and failed to generate an inflationary impulse which suggests that the drivers of inflation are not tied to the unemployment rate. The employment to population ratio has significance. 

The takeaway from the PPI report is that inflationary pressure from the cyclical areas of the report are not suggesting higher rates of inflation are an immediate concern but rather the risk to inflation is to the downside, despite the low unemployment rate.