Schwab Guide To Economic Indicators: Price Indexes

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Schwab Guide to Economic Indicators: Price Indexes—CPI, PPI, PCE and Import Prices
by the Schwab Center for Financial Research
December 11, 2007

What is it?
A price index tracks purchasing power by measuring how the price of goods and services is changing. This generally falls into four categories:

Inflation is the most commonly known term. It refers to rising prices and, therefore, less purchasing power, because it takes more money to acquire the same amount of a good or service. Too much inflation hinders economic expansion.
Deflation is the opposite of inflation. It refers to widespread falling prices and greater purchasing power. Too much deflation also hinders economic expansion because it can curtail spending as consumers wait for lower prices. Not only can this reduced consumer spending hurt corporate profits, deflation can force businesses to sell goods at a price lower than planned, sometimes below cost.
Reflation is when mild inflation returns following a period of stagnant or falling prices.
Disinflation is when prices are rising, but the rate of inflation is slowing.

How is it calculated?
There are three key price indexes, and each makes a different calculation.

The Consumer Price Index (CPI) compares a household's cost for a specific basket of finished goods and services with the cost of the same basket during an earlier benchmark period (reference base, which is the average index level for 1982-84). The weight given to each basket item is fixed.
The Producer Price Index (PPI) uses a similar benchmark approach, but instead measures price changes reported by establishments at the wholesale level, not retail.
The Personal Consumption Expenditures (PCE) price index takes a chain-weighted approach (links weighted averages from one year to the next), which better reflects the changing composition of spending compared to the CPI's fixed-basket approach. For example, it captures the substitution effect characterized by consumers avoiding a spike in higher-priced beef by purchasing lower-priced chicken. The PCE is considered more comprehensive and consistent over time than the CPI and PPI.
The Import Price Index also uses a benchmark approach, similar to the CPI, to measure the change in U.S. dollar prices of goods or services purchased from abroad by U.S. residents.

How is it used?
The Fed uses price indexes to help set monetary policy. If price indexes are rising at an undesirable rate, the Fed may hike interest rates. If price indexes are falling at an undesirable rate, the Fed may cut interest rates. The Fed monitors all price indexes, but the core PCE, which excludes food and energy prices, is its primary price indicator.

The PPI is sometimes used to gauge the CPI and PCE. However, the PPI tends to be more volatile, and can correlate more with the direction but not the magnitude of price changes.

The CPI has many uses. For example, per the Bureau of Labor Statistics, it’s used to adjust income payments to Social Security beneficiaries, military and federal civil service retirees and survivors, and food stamp recipients. It’s also used to adjust the federal income tax structure to prevent inflation-induced increases in taxes.

The Import Price Index is used to help gauge the impact on inflation from changes in the value of the U.S. dollar. It’s an inverse relationship, whereby a lower dollar typically leads to higher import inflation, and vice versa. The impact occurs with a lag, which can vary by industry from a few months to a few years. This index is released as part of a dual report: Import/Export Price Index, yet the export portion rarely garners attention since it doesn’t feed into overall U.S. inflation.

What is its relative importance?
High. Despite being a backward-looking indicator, a price index has a big influence on interest rates, the economy, and stock and bond prices.

What impact does it have on the market?
Stocks and bonds typically fall in reaction to higher-than-expected price index readings (inflation), particularly when the economy is growing near or above its potential. Why? Undesirable rates of inflation can hurt the valuation of stocks and bonds, raise expectations for Fed rate hikes, and eventually lead to a slowing economy.

However, some inflation is necessary in order for consumers and businesses to make spending decisions without feeling it would be smarter to wait for lower prices (deflation). How much inflation is acceptable? An annual range of 1% to 2% is generally considered okay without unduly hurting bond prices.

Lower-than-expected price index readings can lift the prices of stocks and bonds, but there’s a limit with stocks. At first, rising bond prices and falling bond yields enhance the relative attractiveness of stocks. However, stocks can suffer if price index readings keep declining (deflation), especially if the economy is growing near or below its potential. Why? It implies slower corporate profit growth as consumers postpone purchases. As demand slows, this downward spiral can feed on itself, and prices and profits fall further.

When is it released?
For a given month, the Import Price Index and the PPI are typically released first, near the middle of the following month. You can find the latest Import Price Index and PPI figures, as provided by the Bureau of Labor Statistics. The CPI follows a few days later, also provided by the BLS.

The PCE price index is disclosed later in two different forms. The monthly version is released as part of the Personal Income & Outlays report, and quarterly results are included in gross domestic product data. Both are provided by the Bureau of Economic Analysis.

Note: We've only looked at the key price indexes. You can find additional price and wage indexes in a variety of economic reports.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

(2007-5771)

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