Tuesday, March 21, 2006

Unexpected Changes in Rates of Change

Opening up today's paper, you'd have thought something remarkable happened: "Inflation at the wholesale level plunged by the largest amount in nearly three years…much larger than Wall Street had been expecting."

But don't go reordering your portfolio quite yet. A few paragraphs down we learn that the core inflation rate, which disregards energy and food, actually rose by three times the amount analysts were forecasting.

A sensible human being could be forgiven for being confused at this point. Are prices going up or down? Or, are they growing, just at a slower rate? What about energy prices? Aren't energy prices amazingly high right now? Just what exactly is going on?

To parse this problem, think about a car's position, speed, and acceleration. Speed is the rate at which the car's position changes; acceleration is the rate at which the car's speed changes. In this analogy, the price level is akin to the position of the car; inflation is the rate at which prices change, so it's like the car's speed; and changes in inflation are like acceleration.

But there are many measures of inflation. The article mentions two: the overall PPI (Producer Price Index), and the "core" producer inflation rate, which is the PPI of all goods except food and energy. In order to get your head around these, think of the PPI as being the average position of two cars. The position of the first car is the wholesale price of all goods excluding food and energy; it drives along at a sensible, steady clip. The position of the second car represents just food and energy prices; it's volatile, speeding up and slowing down all the time, and sometimes going into reverse.

So what happened this last month? Well, the food and energy car went into reverse, while the core inflation car slowed down a bit. Analysts expected food and energy prices to go into reverse but not by so much. They also expected core inflation to slow down more than the amount it actually did.

1. Do you think it's better to think about the PPI (all inclusive) or the core inflation rate (exclusive of food and energy) when considering inflation? Why?

2. The article mentions the fact that this report may affect the Federal Reserve's thinking on interest rates. If you worked at the Federal Reserve, would this report make you more or less likely to raise interest rates?

3. Why are the prices of food and energy so volatile?

Learn more from the Labor Department's PPI News Release and accompanying data.

Topics: Inflation rate, Price index


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