Chart of the Day: Will Firms Soon Pass on Inflation to Consumers?

One of the most controversial questions in economics right now is whether or not we're in for a high rate of inflation in the U.S. The Federal Reserve took unprecedented measures to provide monetary stimulus over the past couple of years. It says that it can reduce monetary supply effectively to avoid high inflation, but some critics remain unconvinced.

Those interested in this question likely pay some attention to the government reports that come out each month on inflation. There are two major metrics: the Consumer Price Index and the Producer Price Index. In theory, the two should be connected. If prices are rising for producers, eventually they'll have to pass that inflation on to consumers. If they don't, then eventually their costs will overtake their revenue.

That might trouble some market observers, because recently, we've seen producer prices rise more aggressively than consumer prices. For example, the 12-month change for PPI for finished goods in March was 5.8%. For CPI it was just 2.7%. This disconnect isn't new: for about the past year, PPI has been rising much faster than CPI. You can try to blame rising food and energy prices, but they're only part of the story. Here's a chart showing core CPI and core PPI for finished goods (the measures which exclude food and energy) since 2007 (click to enlarge):

cpi v ppi 2011-04.png

There are a few things to note about this chart. Let's start at the right and move to the left. You can see the trend mentioned above pretty clearly -- producer prices have been increasing much more quickly than consumer prices for the past year. Does this mean that producers will be forced to raise consumer prices significantly in coming months?

While that can't be entirely ruled out, if you keep moving to the left on the chart, you see a huge uptick in PPI from about mid-2008 through mid-2009. During this period, producer prices were increasing much faster than consumer prices. Yet in the now nearly two years that followed, we haven't seen CPI jump in response.

How could this be? How are these rising producer prices failing to hit consumers? Over this period producer prices never declined, so one theory could be that firms are just absorbing this inflation. If they are, you certainly can't tell from corporate profits, which have done quite well over the past year.

I asked Brookings monetary policy expert Barry Bosworth to explain. He said that this disconnect is not the result of firms choosing to endure inflation, rather than pass it on to their customers. Instead, it's more a feature of how these two statistics are calculated. Each of these indices give different weights to different items they consider. Variances from index to index in these weights are responsible for higher PPI growth recently, compared to CPI growth.

CPI is a very broad index; it includes goods and services. Although PPI does factor in services to some extent, services have a heavier weight in CPI. As a result, price changes in goods affect PPI more than CPI. Goods have been one of the major areas where we've seen prices rise recently, and that's caused PPI to rise more than CPI. Bosworth added that CPI also tracks housing, the price of which has declined recently. PPI does not track housing. This difference will deflate CPI compared to PPI.

Ultimately, this means that consumers are seeing the prices of some goods rise much more than CPI implies. In particular, those goods tracked by PPI -- even beyond food and energy -- are experiencing more rapidly rising prices. Although consumer prices tend to be sticky, producers must increase them eventually if their inputs experience rising prices.