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Inflation has been on Americans’ minds and a hotly contested issue over the past year. Government agencies have several indicators for tracking that, including the Producer Price Index (PPI). But PPI is more than an inflation indicator — it’s a measure of overall economic health from the viewpoint of producers and wholesalers.

Producer price index definition 

The PPI is a combination of indexes from the Bureau of Labor Statistics (BLS) that measure the average change over time in the selling prices domestic producers get for their goods or services. In other words, PPI tracks inflation as manufacturers or suppliers experience it rather than from the consumer’s perspective.

What does the PPI measure?

PPI wholesale prices can include the first commercial transaction for many products and some services. These eventually trickle down to change the price of goods at the retail level.

About 10,000 individual PPIs are released monthly, covering industries in the goods-producing sectors such as mining, manufacturing, agriculture, forestry, natural gas, electricity, and construction. It also includes trade, transportation, warehousing, finance, healthcare, and other service-based sectors.

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During the pandemic, the final demand PPI index had some of its highest monthly increases in at least the last decade.

How is the producer price index calculated?

The PPI is calculated based on the weighted average price of goods and services produced in the US today relative to the prices of those same goods and services produced during a base year. This ratio is multiplied by 100 to give the PPI figure for that specific good or service during that period.

This process is repeated for each good and service produced in the US tracked by the BLS, comparing how prices have changed across multiple sectors of the economy to indicate which experience the most significant inflationary changes.

How is the producer price index weighted?

Of course, not all goods and services in the PPI are apples to apples. They’re weighted based on their importance in the US economy — and importance is typically determined by the revenue these goods and services generate.

Take apples as an example. Pretend apples comprised most of a fruit market’s sales, while oranges were sold less frequently. Apples, being a larger part of the market’s sales, have a bigger role in the market’s overall economy. Therefore, apple price changes would be weighted more heavily and have a greater impact on the overall PPI.[1]

So, when calculating the PPI, price changes for goods and services representing a larger portion of the total market will have a more significant effect on the overall index than those representing a smaller portion. This way, the PPI accurately reflects the economic sectors with the most impact on overall producer prices.

This weighting process happens in two stages: first, the BLS creates individual indexes for specific groups of goods or services, with items weighted based on their revenue generation.

These individual indexes are combined in the second stage to create an overall PPI. The data used to decide the weights comes primarily from economic censuses, updated every five years.

According to the most recent PPI data, examples of heavily weighted goods-producing industries include automobiles, pharmaceuticals, animal processing, and semiconductors. Similarly, heavily weighted service industries include construction, wholesale and retail trade, food service, and medical care.

Producer price index vs. consumer price index 

The PPI isn’t the only goods and services index to measure the state of the economy. There’s also the fairly more well-known Consumer Price Index (CPI). This index measures the average change over time in the prices urban households pay for a basket of consumer goods and services.

Both CPI and PPI track changes in prices over time. Still, their scope and coverage of goods and services differ: the CPI includes imports and such urban consumer spending as rent and taxed items, while the PPI includes exports, sales to businesses, government purchases, and producer revenues.[2]

The indices are also used differently: the CPI primarily adjusts income and expenditure streams for cost-of-living changes, while the PPI is used to measure real growth in output.

Another way to explain it is that the CPI primarily tracks how inflation impacts consumer prices at the retail level, whereas the PPI tracks inflation as it affects prices during the initial production of goods and services, gradually increasing the cost of these products until they reach consumers.

Like the Core CPI, there is a version of PPI that excludes high volatility items; it’s the index for final demand less foods, energy, and trade services.

How is producer price index related to the health of the economy?  

The PPI provides insight into what’s going on with producer-level prices. By tracking changes in producer prices, the PPI can help economists, policymakers, and investors anticipate these trends and make informed decisions.

For example, if the PPI rises, it might indicate that consumer prices will soon increase, which could lead to higher inflation. Conversely, a falling PPI might suggest that consumer prices will likely decrease, potentially leading to deflation.

However, because the two indices measure goods and services measure, factors like rents, tariffs, and interest rates differently, they don’t always move together. Therefore, movement in the PPI does not necessarily predict activity in the CPI.

PPI, inflation, and deflation 

The PPI measures a form of inflation known as producer inflation. By monitoring price changes from raw materials to finished goods to distribution, the PPI can indicate coming price inflation for consumers. Producers may pass these costs on to consumers through higher prices if they face higher costs. Hence, an increase in the PPI can be a leading indicator of an increase in the CPI.

However, not all producer price increases lead to higher consumer prices. Businesses might instead absorb cost increases due to competitive pressures or other factors.

PPI also measures deflation — when the average level of prices in an economy is falling — in much the same way it measures inflation.

The PPI decreasing from one period to the next indicates that domestic producers receive reduced prices for their output on average. This could be due to various factors, including reduced demand for goods and services, increased supply, or improvements in technology or productivity that reduce the cost of production.

By tracking these decreases, the PPI can provide valuable information about deflationary trends in the economy. For example, a sustained decrease in the PPI might signal that deflation is occurring, which can have significant implications for economic policy.

Deflation is less common than inflation in modern economies, but it can lead to a deflationary spiral, where falling prices lead to reduced production, which leads to layoffs, further decreases in demand, and reduced economic activity.

What is a strong PPI?  

Determining a “strong” PPI is not a straightforward process since it would depend on the context and economic conditions at that given time.

Generally, PPI figures that show moderate, stable increases in producer prices over time are preferable since they indicate no irregularities or sudden changes which could lead to high inflation or deflation.

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Producer Price Indexes
[1]

The application of these weights can vary depending on the type of index, whether it's an industry net output index, a commodity grouping index, or a Final Demand-Intermediate Demand index. Each type of index uses a slightly different method to determine the weights, ensuring that the PPI accurately reflects the importance of different goods and services in our economy.

[2]

It excludes taxes and excluding imports. The PPI does not include the price of imported goods, unlike the CPI. Conversely, the PPI includes export prices while the CPI does not.