Inflation has been on Americans’ minds in recent years as rates have reached 40-year highs. Government agencies have several indicators for tracking inflation, including the Consumer Price Index (CPI) and its lesser-known counterpart 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 for goods or services produced domestically. In other words, PPI tracks inflation as manufacturers or suppliers experience it rather than from the consumer’s perspective.
What does the PPI measure?
The PPI aims to track prices of all output from US producers. This includes goods and services that are purchased by other producers, sold directly to American consumers, and exported to international buyers.
In addition to the overall PPI, about 10,000 individual PPIs are released monthly, covering goods in the production sectors such as mining, manufacturing, agriculture, forestry, natural gas, electricity, and construction. It also includes services provided in industries within trade, transportation, warehousing, finance, healthcare, and other service-based sectors.
During the pandemic, the PPI index reached its highest year-over-year rates of increase than at any point in past decade.
How is the producer price index calculated?
The BLS calculates PPI 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 and tracked by the BLS, comparing how prices have changed across multiple sectors of the economy.
How is the producer price index weighted?
Goods and services included in the PPI can’t always be compared as 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. Imagine apples comprised most of a fruit stand’s sales, while oranges were sold less frequently. Apples, being a larger part of the stand’s sales, have a bigger role in the stand’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.
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This weighting process happens in two stages:
- First, the BLS creates individual indexes for specific goods or services groups, weighing items based on their revenue generation.
- Second, the BLS combines these individual indexes 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 and pharmaceuticals, while heavily weighted service industries include retail, food service, and medical care.
Producer price index vs. consumer price index
The PPI’s cousin — the CPI — measures the average prices urban households pay for consumer goods and services.
Both CPI and PPI track prices over time. Still, their scope and coverage 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 measures real output growth.
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.
Like the core CPI, there is a version of PPI that excludes high volatility items; it’s known as the index for final demand minus foods, energy, and trade services.
PPI, inflation, and deflation
The PPI is used to measure producer inflation, or the rise in the PPI over time. 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.
When PPI decreases from one period to the next, it means that, on average, producers are getting paid less for what they make. 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. Deflation is less common than inflation in modern economies.
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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[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.
