Don’t Be Fooled by the PPI: Inflation Is Coming

Source: Thinkstock

Source: Thinkstock

The Producer Price Index (the “PPI”) fell by 0.1 percent in May versus an estimated increase of 0.2 percent. It also rose by 0.6 percent in April.

The PPI is a statistic released by the U.S. Government’s Bureau of Labor Statistics. It measures the rate at which prices are rising from the standpoint of producers. If producer prices rise, it means that businesses are paying more for input products and this either eats into their profit margins or they pass these costs on to consumers. If the PPI falls, then businesses are paying less for these products, and this generally improves these businesses’ margins. Note that while businesses will potentially increase prices to consumers if their input costs rise they are less likely to do the opposite if prices fall unless sales are weak and they need to entice customers.

While the falling PPI may appear to be good news a few things need to be kept in mind. The first is that the PPI rose by 0.6 percent in April, and this is a tremendous increase. This annualizes to a 7.4 percent inflation rate. So unless we are now entering an era of high inflation one would expect the PPI to retreat a bit. It is similar to when a stock rises substantially on good news such as a positive earnings release—it usually retreats during the following trading session. If you follow commodity markets you know that the prices of many commodities from agricultural products to energy fell in May, but this is after a fairly strong first four months of the year.

Note that, for example, several consumer products companies [e.g. Kraft (NASDAQ:KRFT)] announced sizeable increases in retail coffee prices as the price of coffee skyrocketed in the first part of the year. The coffee price fell in May, but that didn’t stop companies from rising prices.

Investors should also note that nickel retreated in May, and yet due to tensions in the Ukraine and a new Indonesian regulation the price of nickel skyrocketed at the beginning of the year, and so a correction was inevitable. Russia is the second largest nickel producing country, and Indonesia disallowed nickel exports that didn’t have some value added to them within Indonesia’s borders, and this has created a mini supply shock.

The second is that, while the PPI fell in May, we are seeing strength in several commodity markets in June, and this doesn’t bode well for businesses or consumers. The most obvious culprit is oil, which trades at about $107/bbl. Also note that one of the best performing ETFs this year has been the United States Oil Fund LP “USO.” The United States Gasoline Fund LP “UGA” is trailing behind, but it is up a whopping 4 percent in just the last week. If tensions continue to mount in Iraq the rise in the price of oil will continue, and the decline in May’s PPI will seem like a distant memory.

Other strong commodities in the month of June include precious metals, and platinum and palladium in particular. Platinum and palladium are primarily used in catalytic converters which reduce carbon emissions by automobiles, and so this is a commodity spike that touches everybody.

So with the price of oil rising and with strength in several other commodity markets I suspect that the decline we saw in the PPI in May will quickly reverse itself, and we will be on the path towards higher prices—both at the producer and consumer levels—in the coming months.

Investors who wish to take advantage should consider buying commodity ETFs. If you don’t want to cherry-pick commodities there are a couple of broad commodity funds. The most popular is the DB Commodity Index Fund (NYSEARCA:DBC), although investors might want to opt for the less liquid, yet more diversified the Rogers Commodity Index Fund “RJI.”

Disclosure: Ben Kramer-Miller has no position in any of the securities mentioned in this article.