Inflation Cycle Downturn - Market Analysis for Oct 8th, 2019

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 is the most market-sensitive inflation measure and thus is one of the most closely watched inflation reports for bond market participants. 

The PPI report is far more market sensitive and leading compared to other widely followed inflation reports such as the consumer price index. 

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 metrics from the PPI report continued to highlight a deceleration in the rate of inflation while the more cyclical sub-components suggest downside pressure has not yet eased. 

Yesterday, in our [Quarterly Themes] report, we highlighted downside inflation pressure as one major issue to watch over the coming months.

The headline producer price index decelerated to 1.37% year over year from 1.80% last month. This marks the weakest growth rate since November 2016, a 34-month low and 14-months since the peak in cyclical inflation pressure in the summer of 2018. 

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

Core PPI, which excludes food and energy, decelerated to 1.90% year over year from 2.34% last month. This is the weakest reading for core producer price growth since June 2017. 

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

Removing trade services from core producer prices emphasizes the ongoing cyclical downturn in inflation, falling to 1.65% year over year, a 35-month low.

US PPI Final Demand Less Foods, Energy, and Trade Services Year over Year (%):Source: BLS, Bloomberg, EPB Macro Research

If we separate the producer price index into two categories, goods and services, we can see the goods component has re-entered deflation, falling 0.52% year over year, the weakest reading in 37-months. 

US PPI Final Demand: Goods Year over Year (%):Source: BLS, Bloomberg, EPB Macro Research

Inflation in the service sector is far less cyclical. The rate of increase has stalled at 2.31% while the decline is still centered in the more cyclical areas. 

It is critical to focus on the cyclical areas of inflation (or growth) and not discount them as "smaller" subsets of the economy because as the economic sequence unfolds, trends typically move from more cyclical sectors to less cyclical sectors. 

US PPI Final Demand: Services Year over Year (%):Source: BLS, Bloomberg, EPB Macro Research

Highly cyclical areas of inflation are showing continued deflationary pressure. The PPI for industrial chemicals is down more than 15% year over year, showing virtually no signs of easing pressure. 

US PPI Industrial Chemicals Year over Year (%):Source: BLS, Bloomberg, EPB Macro Research

Industrial commodities less fuels and power, another cyclical area of inflation, also showed continued disinflationary pressure, falling 0.87% year over year. 

US PPI Industrial Commodities Year over Year (%):Source: BLS, Bloomberg, EPB Macro Research

A large reason for the vocal call this quarter for a decline in inflation expectations was due to the ongoing decline in the price of sensitive industrial commodities. 

A continued decline in the price of a basket of less liquid industrial materials, not easily impacted by futures speculation, argues against cyclical inflationary pressure building. 

CRB Industrial Commodity Prices:

Source: Bloomberg, EPB Macro Research

The latest update from the CRB (published each night) showed one of the largest one-day declines in the index of industrial materials. 

Should this decline in industrial commodities persist and even get worse as the latest data point suggests, the bias for inflationary pressure is skewed massively lower, regardless of the core CPI reading which is highly correlated to the business cycle with a significant lag. 

Let's not forget the Core CPI accelerated to 2.5% in August of 2008 before declining to 0.6% in October 2010 - far from a great economic indicator. 

Staying focused on the cyclical areas of inflation continue to suggest the bias for inflation expectations remains lower.