The Producer Price Index rose a shockingly high 1.8% in June, far higher than the tame readings of 0.2% in May and 0.3% in April. It was also much higher than the 0.9% consensus expectation.
To be sure, most of the acceleration had to do with the rise in energy prices, which rose 6.6% on the month on top of a 2.9% rise in May. In May, the rise in energy prices was largely offset by a 1.6% decline in food prices. That left the May change in Core PPI at a slightly negative 0.1%.
That was not the case this time around, as finished food prices jumped 1.1% to help fuel the increase in the headline number to its highest level in over a year. However, even if we take out food and energy to get the Core PPI, the increase came in at 0.5%, well above expectations of a 0.1% increase.
The PPI is released at three levels, with the index for finished goods being the one that gets the most attention (i.e. what I talked about first). It also looks further up the production chain to see what is happening to prices at the Intermediate and crude stages of production. The easy way to conceptualize the differences is to think Wheat, Flour and Bread to represent Crude, Intermediate and Finished goods.
Prices are starting to accelerate up the production chain as well. To some extent this is a good thing, since the early stages of production had been showing serious signs of deflation. On a year-over-year basis, intermediate goods prices are down 12.5% and crude goods are down a whopping 40.0%.However this month both staged large increases with intermediate goods rising by 1.9% and crude goods jumping by 4.6%.
Energy was the principal reason at both levels, rising 8.9% at the intermediate, and 10.9% at the crude level, following increases of 2.0% and 5.3%, respectively in May. The fact that energy prices are rising much more in the early stages of production than at the finished level is bad news for refiners like Valero (VLO) and Tesoro (TSO). For the integrated giants like Exxon (XOM) and Chevron (CVX) the effect is likely to be a wash.
The year-over-year numbers are a bit deceptive. If we break the year into the last half of 2008 and the first half of 2009, the difference in the behavior of the PPI numbers is startling. Looking just at the finished goods numbers, in the last half of 2008, overall finished goods prices plunged at an annual rate of 12.1%, but in the first half of this year they are up at a 4.2% pace (annualized the June rise would be at a 23.9% pace). However, that was almost all a function of energy, which plunged at a 52.9% rate in the last half of last year, but are climbing at a 18.8% rate so far this year.
On a core basis, PPI has actually be going up at a relatively tame 2.9% rate, well below the 4.6% rate it was rising late last year. The core rate is significant because the Fed tends to look at it more than the headline rate in setting monetary policy. To the consumer it is less significant, since most people have to consume both food and energy.
The traditional rationale for the focus on the core rather than on headline is that over the long term, food and energy price changes will tend to match the overall price level, but they can be very volatile in the short term and are vulnerable to exogenous shocks. Thus they could cause the Fed to “over-steer” in setting monetary policy. The rise in the core rate has to be a bit disconcerting to the Fed, especially if it is matched by a similar report on Consumer Prices tomorrow.
The traditional medicine for fighting incipient inflation is to raise the Fed Funds rate. However, with unemployment at 9.5% and rising, such a move seems ill-advised. It is hard to see how the wage side of a wage price spiral can get underway in these conditions, so any rise in inflation simply means a reduction in the real standard of living for the vast majority of Americans.
Still, the aggressive policy moves by the Fed — reducing Fed Funds to almost zero and engaging in quantitative easing (a.k.a. turning on the printing press) — are inflationary by their nature. They were put in place to fight off the deflationary effects of the private sector attempting to deleverage.
Getting the balance right, and sopping up the liquidity used to fight that deflationary fire, is going to be tricky. I’m sure that the Fed does not want to have to do that yet.
I have long thought that the current problem was deflation but that inflation was a very big risk for late 2010. If that switch-over comes early, before the economy has had a chance to at least stop the rise in unemployment, the Fed is going to be in a serious bind.
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