Which Economic Indicators Can Help Investors Understand Inflation?

The typical investor focuses on the monthly change in the retail price index for goods and services and thus reads the end of a long chain of pressures building up in raw material markets and then passing through to production costs and retail prices and on to wages and interest rates.

Looking at these numbers in terms of forecasting helps to understand what each number tells us. In terms of forecasting for early warning of cost pressures vs. Confirmation of cost pressures, and how central banks will use inflation numbers to guide policy, all of these indicators give different perspectives on the same inflation data.

Producer prices as an upstream signal

The Producer Price Index (PPI) measures the prices that domestic producers receive for their output. These prices are typically measured by stage of production and by industry (i.e. Mining, manufacturing, etc.). Thus the PPI can be a useful leading indicator for subsequent changes in the CPI. What is PPI?

In aggregate, the PPI is not a very valuable release, and it is worth going over what PPI is in detail before leaning on the headline number. It is the detail in the PPI that matters, especially the PPI’s Intermediate Demand categories for goods and services. Specifically, are price increases for energy and for foodstuffs becoming more concentrated, or is the spread between them widening?

How to read the pass-through

There is a significant delay in the ‘pass-through’ of costs to retail prices. Many of the increases are absorbed by producers’ and suppliers’ margins. Others are the result of very competitive industries, which are able to keep their prices down. Some cost increases are delayed due to the existence of long-term contracts. It may be some time before the cost of books printed in the Far East starts to show in printed books on Western high-street shelves.

• Compare producer and consumer series for the same category, such as food or motor vehicles, rather than at the aggregate level.
• Watch the gap between producer output prices and input costs as a proxy for margin pressure across sectors.
• Treat trade services components with care, since they measure margins rather than prices and can distort the headline.
• Check whether a move is driven by one volatile commodity before drawing conclusions about breadth.

Consumer prices and the components that actually matter

This view of CPI exposure is heavily biased toward non-tradables and in particular to highly weighted shelter costs. As such, this is a component of exposure that is generally slow moving and hence can persist for extended periods in contrast to other exposure to price indexes that are heavily weighted to tradables.

The rest of the data points form two groups of non-cyclical data. Medical services and education are examples of non-cyclical data points. Administered prices and others also form a group of their own non-cyclical data points. And, among the non-cyclical services, the core services excluding shelter is the most relevant data point to track the transition of inflation from a supply-side shock to a domestic, wage-sensitive phenomenon.

Choosing between the available measures

Employment data and the persistence question

The information from the various labor market indicators discussed above is relevant to a different question. The question of whether or not price increases are financed with corresponding increases in wage income is an important one. Most prices experience large permanent declines in real terms over long periods of time as the result of supply shocks (e.g. Fruit prices in the early 1980s). The majority of prices, however, which experience increases due to increases in unit labor costs, typically experience permanent increases in real terms over long periods of time.

Average hourly earnings for production and non-supervisory employees on private non-farm payrolls is likely to be the fastest of these average hourly rates to rise but will inevitably be affected by the changing composition of employees. The Employment Cost Index has the disadvantage of being published much less frequently than average hourly earnings but is a far cleaner series than most of the average hourly rates. Unit labor costs equal compensation per employee plus productivity and are only likely to exert upward pressure on selling prices if they are rising.

Secondary labor indicators worth tracking

1. The quits rate, as a measure of worker bargaining power and wage pressure ahead of formal earnings data.
2. Vacancies relative to unemployed workers, which indicates the degree of labor market tightness.
3. Average weekly hours, which firms usually adjust before headcount and which therefore turns early.

Interest-rate expectations as the market’s own forecast

For rate markets, the average of all available data points could be traded against an alternative view. For a forward looking view of inflation, the inflation forward curve, overnight index swap rates for short-dated maturities as well as the spread between nominal and inflation-linked interest rates for all available government maturities are more useful than any private inflation forecast.

Another way to look at breakeven rates is to consider how short- and long-dated breakevens are moving. If short-term breakeven rates are rising but long-dated rates are falling, then markets may expect the current round of cost pressures to ease soon.

Building a workable framework

One proceeds through the data in sequence, beginning with the data on commodity/producer prices and hypothesizing cost pressures at the production stage. Retail price data for consumption stage prices can then confirm whether these costs are translating into higher prices. The labor market data provides an indication of whether such higher prices are actually funded. And finally, rate market data indicates what has already been priced into assets by investors.

The discrepancies across indicators are more relevant than the discrepancies within each indicator. Thus, the decline in the Producer Price Index for manufacturing combined with an increase in the core services Consumer Price Index for example, enables us to concentrate on the exposure composition rather than on the change sign in the aggregated indicator.