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VERSACE: Economists eye PPI, CPI for any hints of inflation

- The Washington Times - Friday, December 18, 2009

OPINION/ANALYSIS:

There was a plethora of economic data out this week ranging from housing starts and jobless claims to the Philadelphia Fed Index on Friday.

While it is important to keep tabs on all of these data points, the two that were put under the microscope this week, and for good reason in my view, were the Producer Price Index (PPI) and the Consumer Price Index (CPI). Both data streams revolve around price increases for goods and services - i.e., inflation.

Inflation is a hot topic now and for several reasons, as a sustained upward move in prices has a ripple effect. The ripple effect can be good for some companies and bad for others, but it usually tends to be bad for the average consumer.

In terms of average consumers, if their income and wages are not rising in an inflationary environment, each dollar they have buys fewer goods and services. Considering the current economic picture characterized by significant unemployment, slack in the manufacturing sector and consumers that are at best hesitant to spend, any signs of inflation could stymie the tepid recovery that many talking heads are championing.

The data released this week showed a higher than expected move in PPI, up 1.8 percent for November compared with the consensus expectation of up 0.8 percent. By comparison, the CPI for November was in line with expectations of up 0.4 percent. The next question to ask is - what is the difference between the PPI and CPI? In a nutshell, the PPI reflects the average change in selling prices received by the producers of goods and services, while the CPI is a measure of the average change over time in the prices paid by consumers for a basket of goods and services.

So why was month-over-month change in PPI above expectations but the month-over-month change in CPI as expected?

To answer that, we need to first understand the difference between demand-pull inflation and cost-push inflation. The theory behind demand-pull inflation says that if demand is growing faster for goods and services than supply, prices will increase. Generally speaking, this reflects a growing economy but can also showcase hot items, such as Nintendo's Wii during the holiday season last year. By comparison, cost-push inflation says that as a company's costs rise it needs to increase its prices to maintain its level of profitability. The costs that most people tend to think of are basic raw materials and energy, but other costs that drive cost-push inflation include costs associated with benefits, such as health care, wages and taxes.

Are we experiencing a period of demand-pull inflation? Doubtful is my answer. Looking across the sea of economic data, I don't see any meaningful signs that the demand for goods is rising significantly faster than the ability to produce them. With manufacturing capacity utilization at 71.3 percent for November compared with the recent peak of 81.2 percent in August 2006, there is ample slack in the economy. Looking at Institute for Supply Management data for both manufacturing and services shows a similar picture.

Are we seeing signs of cost-push inflation? Yes, but not across the board. Are we seeing wages increase? No, and I would argue that with current unemployment levels, we are not likely to see upward pressure on wages in the near term.

What about raw materials and other inputs, like energy? After perusing cash prices for commodities and comparing current prices with those from a few weeks ago or even a year ago, I would have to say there are pockets of higher input costs. Crude oil prices, and subsequently gasoline prices, are higher than levels in December 2008. Case in point, the cash price for Brent Crude oil was $73.26 compared with $42.26 a year ago. Gold prices recently touched $1,140 per troy ounce, up almost one-third from $872 a year ago. Other precious metals such as silver and platinum as well as other metals including aluminum, copper and zinc are also up dramatically year on year. Foods, grains and other commodities are a mixed bag. Beef and cheese prices are down year on year, but coffee, milk and butter are up significantly versus year-ago levels.

Back to the difference for both PPI and CPI compared with their respective expectations for November, it's difficult to determine when increases in the PPI will appear in the CPI, and in some cases it may not. Increases in oil prices are reflected rather quickly at the gas pump, but there is a lag as companies consume their inventories. Similarly, products made with higher input costs need to make their way through distribution and warehousing until they reach the retail shelf. While the PPI will reflect the higher cost in manufacturing those products, the corresponding CPI will not show the change until those products reach the stores.

Normally the trend in commodity prices will take some time to be reflected in consumer prices and consumer trends. Given the unemployment rate and the trading down effect that we are seeing, I suspect consumers are eschewing higher-priced goods and services in favor of low-cost alternatives. It's why we use Gain now instead of Tide. While this will restrain inflation, past a certain point rising input costs will drive the CPI higher. Hopefully, this is after we have seen a pickup in job creation and wage growth; if not, this would-be economic recovery could be short-lived.

Chris Versace is director of research at Think 20/20 LLC, an independent research and corporate access firm based in Reston. He can be reached at cversace@washingtontimes.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.