When making decisions about investing in any assets, it is necessary to analyze not only the performance indicators of specific companies, but also the external environment - the economic situation in the country and individual industries. Indicators for tracking the "temperature" in the economy are macroeconomic data: unemployment rate, GDP dynamics, consumer inflation, etc. At the same time, it is important for an investor to assess not only the current state of the economy, but also to see its future. To do this, there is a whole set of leading indicators that signal in advance about future changes in the economy. One of these indicators is the producer price index PPI, which is considered one of the first indicators of inflation.
Inflation, to use a phrase from the famous cartoon "a strange object, it seems to be there, but it does not seem to be there." But this is relevant only in situations where inflation is within the normative value. But when there is a significant deviation from the norm, then everyone begins to feel it on their wallet, and the investor – on the dynamics of their trading account. The PPI index allows you to anticipate the growth of consumer inflation in advance and predict possible stock market movements. "Informed means armed" - you can prepare in advance for an inflationary cataclysm by competently building the structure of your investment portfolio.
What is the PPI index?
The PPI index, Producer Price Index, is one of the leading economic indicators reflecting the dynamics of inflationary processes at the production stage, that is, at the earliest stages of product creation. It shows the dynamics of changes in wholesale prices for goods sold by manufacturers, that is, this is a change in the price of individual components and finished products until they hit the shelves. The PPI index can quickly show trends emerging at the very initial stages of production.
At the same time, it should be understood that the PPI index is not a direct indicator of inflation, but its growth may be a signal of an increase in inflationary processes in the economy: increased selling prices for individual goods and components lead to an increase in the cost of manufactured products. In order not to work at a loss and maintain a certain profit margin, manufacturers will be forced to raise prices for their products. That is, the increase in production costs is shifted to the end user, who may be able to purchase a smaller amount of goods for the same amount than before. But this is consumer inflation in its direct manifestation.
The well-known consumer price index (CPI, Consumer Price Index) characterizes the change in prices at the level of final sales, i.e. at the buyer. That is, this is the final stage of the inflationary process, when consumers feel the price increase in their wallet. But prices first change at the producer, and then on the "shelves of stores", that is, at the retail level of the buyer. As a result of this increase, the CPI is also growing.
That is, so that there is no confusion, let's summarize:
- The Consumer Price Index (CPI) is an indicator of cost price changes, it is felt by manufacturers.
- The Producer Price Index (PPI) is an indicator of changes in the price of final products on the "shelves of stores", it is felt by consumers.
Taking into account the duration of the production cycle, the growth of the PPI index may not immediately affect the growth of consumer inflation. Usually the time lag is from 3 to 6-8 months. Also, the growth of the PPI index may not always lead to consumer inflation for the following reasons:
- Index calculation methods cover different parameters. When calculating PPI, services, imports, taxes are not taken into account, that is, it is exclusively an increase in the prices of industrial goods, while CPI is calculated for a certain basket of consumer goods, and also includes services, imported goods and fiscal fees.
- Compensation of manufacturers' inflation by manufacturers themselves or by retail. The increase in the cost of industrial goods at the manufacturer's level can be compensated by optimizing the costs of the manufacturer itself, that is, the manufacturer does not raise the price of its goods and prices on the shelves remain unchanged. But even if the manufacturer raises the selling price, retail chains can compensate for this increase at the expense of their other expenses.
That is, forecasting consumer inflation based on PPI dynamics over short time intervals can lead to erroneous conclusions. At the same time, there is a direct correlation between CPI and PPI on deep investment horizons: if a consistent increase in the PPI index is observed for a long time, then this naturally leads to an increase in the consumer price index and an increase in the inflation rate. Conversely, the same long-term decline in industrial inflation leads to a decrease in the consumer price index (a decrease in inflation). Since inflation is a key indicator of monetary policy, the economic regulators of the countries closely monitor the PPI index and, if necessary, adjust the rhetoric regarding interest rates.
Read more: What is the Consumer price index CPI
The method of calculating the PPI index
The analogue of the modern PPI index was created in the USA in 1891, until 1978 it was called not the producer price index, but the wholesale price index. The method of its calculation has changed several times since its appearance, but it is believed that the index data is continuous, and they can be compared for the entire calculation time. Data on the index is calculated monthly and published by the U.S. Bureau of Labor Statistics.
The Bureau of Statistics publishes about 10,000 PPI indices for individual goods and their groups based on questionnaires filled out by manufacturers about the prices of the goods they produce. More than 25,000 companies participate in the surveys, providing data on prices for more than 100,000 commodity items in almost all industries. Participation in surveys is anonymous.
PPI indices are calculated for each stage of production (procurement, intermediate, production of finished products) and for all sectors of production (mining or mining, agriculture, industry).
The analysis of the indices of individual production stages allows us to conclude at the expense of which component the final cost of products increases. Usually, the PPI change is analyzed as a percentage relative to the previous month, as well as on an annualized basis.
The family of PPI indexes can be grouped:
- By industry – a group of indices that measure the change in cost by industry. With the help of their analysis, it is possible to understand the situation in various sectors of the economy. As a result of summing these indices, with the exception of food and electricity, the main PPI is obtained. Excluded industries have strong volatility and can give a misleading signal. This composite index is most often used as an indicator of industrial inflation.
- By product - one or more products with properties characteristic of this group are selected from each product group.
- By stages of processing: raw materials, intermediate stages and final products. That is, goods produced at a certain level that will be sold to other manufacturers to create finished products. But recall that the growth of these indices does not always lead to an increase in the cost of finished products, because it can be offset by a decrease in other costs.
When calculating PPI, the current price of one or a group of products is divided by their base price. The base price is the price of 1982, which is conditionally equal to 100. If the index value is greater than 100, it means that prices have increased compared to the base, if less than 100, they have decreased. You can also compare the change relative to the same period last year or month.
Read more: What is the Consumer Confidence Index (CCI)
The producer price index for each commodity group is calculated by the formula:
- PPIi is the consumer price index for a product or group of products in the current period.
- Pricet - the price of a product or group of products in the current period,
- Priceb - the price of a product or group of products in the base period.
The consolidated producer price index is calculated taking into account changes in production inflation of all commodity groups:
- n is the number of industrial goods included in the index,
- Di is the specific weight of each product in the index. The components are weighted according to their contribution to GDP.
The base price of a product or a group of products in 1982 is taken as 100. It is logical that the prices of 2022. they will exceed the base parameter by several hundred times, and the dynamics of the PPI index will almost always be only up.
But such a fact cannot be interpreted as a negative scenario for the simple reason that the economy of 1982 and 2022 is characterized by a completely different order of parameters: production volumes have increased, the level of GDP has increased. In addition, a gradual moderate rise in prices or inflation is a positive moment for the economy. So in order to understand how the PPI index has changed (within the norm or with a deviation), it is considered to be a change in PPI values from year to year or month to month.
How to use the PPI index for an investor
By tracking PPI indices, you can get signals about changes in the economy before they are actually reflected in other official indicators. And first of all, the integrated PPI index allows us to anticipate the growth of consumer inflation.
As you know, moderate inflation (for the economies of different countries, the standard is different: for Russia 4%, the USA 2%) has a positive effect on the economy and leads to a steady growth of the stock market. A significant increase in inflation leads to a decrease in consumer spending, a decrease in production, an increase in unemployment, and a decrease in economic activity. The downturn in the economy is reflected in the general decline in the stock market. Therefore, it is important to assess the dynamics of PPI - a steady increase in production inflation will be a signal of future consumer inflation growth.
Also, changes in the index can be interpreted differently depending on the phase of the economic cycle:
- When the economy is in a growth phase, increased price pressure may lead to a revision of monetary policy in favor of raising rates. An increase in the rate leads to an increase in the cost of loans in the economy, which in turn has a negative impact on stock markets.
- At the stage of economic downturn, an increase in the index may have a negative impact on industrial companies. They will shift the increased costs to buyers to a small extent through price increases due to fears of losing market share. An increase in costs and the lack of compensation for this growth can lead to a decrease in efficiency - a decrease in profits and even losses.
Investors, as a rule, analyze the change in the index values compared to the previous month, as well as their deviation from the consensus forecasts of analysts. In Russia, at the investor level, forecasts for this indicator are not tracked, since such statistics are not available in open data sources.
Below is an example of actual and forecast PPI values for the US market. When the actual PPI value corresponds to the forecast or is below the forecast level, this does not cause a negative reaction among investors. But when there is a significant deviation from forecasts, namely excess, it is regarded as a local negative driver, against which you can see corrective movements in the stock market. This is especially noticeable in the US market. However, there is no net impact of PPI statistics on the market. Market movement, especially in the short and medium term, is a combination of factors.
The market is also interested in two aspects contained in the PPI report:
- How fast prices are rising: if the PPI growth is significantly higher compared to previous months, the market checks where it came from, i.e. which components influenced the growth.
- Do manufacturers transfer price increases to consumers: this aspect is checked after the release of the CPI report.
And most importantly, it is important for an investor to monitor the dynamics of PPI in terms of the subsequent increase in inflation, which affects financial market instruments. This action is not direct. It is assumed that a sharp increase in industrial inflation may lead to an increase in consumer inflation. The key lever of the economic regulators of the countries in the fight against the increased price is an increase in the rate (the Fed rate in the USA).
- Stocks. The gradual or planned growth of PPI is a positive phenomenon. Moderate inflation in the economy has a stimulating effect. The positive impact is associated with a moderate increase in prices, which stimulates purchases, due to which the revenue of companies is growing, followed by a gradual increase in wages, unemployment is decreasing, production is growing. Moderate inflation corresponds to finding the economy in a phase of economic growth. The stock market, as a significant part of the entire economy, shows growth during such periods. A stable sharp increase in the index means an increase in producer costs. Locally, this may lead to a reduction in company profits, and in the future to an increase in consumer inflation, an increase in economic rates, which will negatively affect stock markets. During periods of rate increases, and even the rhetoric about their increase, the market "goes" into correction.
- Bonds. Changes in PPI as a reflection of future changes in inflation and rates in the economy also have a direct impact on the debt market. High price inflation, in general, has a positive impact on the debt market. An increase in the rate in the economy, and even the rhetoric of its increase, leads to a drop in bond prices and an increase in the yield of "old issues" with fixed yields. Long-term bond issues are particularly sensitive to rate increases. At the same time, a high rate means an increase in coupon yield on new issues. That is, in fact, a high rate leads to an increase in the yield of bond instruments: on old issues due to a discount, on new issues due to an increase in coupon yield. During periods of high inflation, investors prefer bonds as conservative fixed-yield instruments.
- FOREX (Foreign exchange market). High rates in the economy, as a consequence of the growth of production and consumer inflation, have a favorable effect on the national currency. Investors prefer to keep their savings in a currency that guarantees more income (with an increase in rates, the profitability of deposits also increases). In addition, high rates contribute to the inflow of foreign capital into the economy.
You can track the output of data on inflation and other important macroeconomic indicators for the investor using the Economic Calendar.
The PPI index provides information on changes in prices for goods and services at various stages of the production chain, i.e. it acts as a leading indicator that informs about the direction of inflation in the economy. A moderate increase in inflation at the level of producers and consumers has a stimulating effect on the economy. But when we observe that producer inflation shows a sharp increase, and this trend persists for several periods, it is a likely signal that companies will shift the increase in costs to consumers, which will lead to an increase in retail prices. Accelerating consumer inflation is no longer a very good parameter for the economy. For central banks, this is a signal to curtail the policy of soft rates, and for investors, it is a signal of serious changes in the financial markets.
The best way to reduce the risk of inflation growth for an investor is to have a well—diversified portfolio. Both stocks and bonds can perform an anti-inflationary function. During the period of "inflationary fire" in the economy, you need to be ready for corrective movements in the market. But if the investment portfolio is balanced by protective and risky assets (in the ratio of 80/20), the correction can be completely painless. But there is one condition – the right choice of assets.