This column was originally published on RealMoney on Oct. 18 at 12:46 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.Looking at the highlights of the producer price index, or PPI, is like takinga time trip through key dates in U.S. history. Surging energy costs are the fuel for this trip, and they are also thesource of a key debate facing both the Federal Reserve and investors, asthe gain in overall inflation continues to be much larger than the gain inother prices. Whatever the case, the data will do little to ease concernsabout inflation and will feed consumers' inflation expectations, which arealready high. The producer price index rose 1.9% in September, which was seven-tenths ofa percentage point more than expected and the largest monthly increasesince 1990. It was also the second largest increase since November 1974.On a year-over-year basis, the PPI is now up 6.9%, the most since November1990, when it was 7.0%. Excluding food and energy prices, the so-calledcore PPI rose 0.3%, one-tenth of a percentage point more than expected.The year-over-year gain in the "core" is now 2.6%, not far from the 14-yearhigh of 2.8% seen in July.
Large Gains in Pipeline DataThe worst of the day's news could well be the data on "pipeline" inflation. Crude materials, or materials at the earliest stage of production (rawmaterials, for example), rose 10.2% in September, the largest monthly gainsince March 2003. Core crude goods, or crude goods minus food and energy,rose 5.3% during the month, the most since July 2004. Except for thatmonth, the gain in core prices was the most since July 1976 (the U.S.bicentennial). As an illustration, cotton from the field would be crudematerials for a shirt. Intermediate prices, which are those prices that occur at the middle stageof production and that have the closest correlation to the headline data,rose 2.5% overall, the most since August 1974 (Nixon resigns). Core pricesrose 1.2%, the most since November 1980 (Reagan wins). Using the sameshirt example, the intermediate material would be cotton yarn. Thefinished good would be the shirt itself.
Causes of Muted Market ResponseThe market response to the PPI has been muted thus far because it is agrade-B inflation gauge that generally tends to garner very little marketresponse. The Oct. 28 release of the personal consumption deflator, theFed's top inflation gauge, will be more important to the markets. The PPI's value is reduced by the fact that it reflects well-known trendsin commodity prices and because it reflects more on the goods sector thanthe service sector, which is the largest sector of the U.S. economy. Formany of you working in offices, it is easy to understand this concept; asubstantial part of your company's expenses are related to labor, not rawmaterials and parts. Labor accounts for about 70% of the inflation processin the overall economy. Currently, labor costs are contributing to theinflation problem, with unit labor costs up 4.2% vs. a year ago, the mostin five years and above the 15-year average of 1.7%. Also limiting the market response is the fact that companies suchas General Motors ( GM) and Ford ( F) are experiencing the higher costs seen todayin the PPI report, yet they are passing very little on to the consumerthese days. The PPI is akin to the prices-paid component of the ISM index, while theCPI is closer to the prices that manufacturers receive from theircustomers.
50-Basis-Point Hikes Could Stamp Out Inflation WorryDespite the grade-B nature of the PPI report, the gain will feed inflationexpectations, a major worry for the Fed and the markets. Still, the widedisparity between the gain in overall prices and the gain in core prices(September's monthly change was the most since 1990 and the second mostever) stokes the debate over how much emphasis investors should put on theoverall index vs. the core index.
One of the things we learned in the 1970s is that expectations are really, really important. Energy prices might affect underlying inflation by affecting inflation expectations about future inflation."Notice Kohn's emphasis on how important expectations are ("really,really"). Until the Fed has squashed inflation expectations, its battleagainst inflation will not be over. This means that the overall inflationrate will be held high in importance even if the core rate rises at amoderate pace. One scenario for accomplishing this is the possibility that the Fed willdeliver another one or two quarter-point hikes in the fed funds ratefollowed by a 50 basis point hike or two. This is the way the Fed hasoperated since Greenspan took the helm in 1987 and it has been an effectiveway to put an "exclamation point" effort to stamp out inflation. Sure, the Fed might deliver these hikes when it appears that they areunnecessary, but that is the point. At that stage any notion ofaccelerated inflation and of further rate increases would begin to fade,setting the stage for a more stable period of inflation, economic growthand the financial markets. P.S. from TheStreet.com Editor-in-Chief, Dave Morrow:
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