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Producer Prices Don't Necessarily Lead Consumer Prices

   

The government regularly churns out reports about inflationary trends, which are critical information for bond traders, money managers and others. After all, a surge in inflation will hurt bond prices while falling inflation will help them.

But inflation can occur at different levels of the economy and have different effects. If inflation is confined to the production level, it may not have much of an impact on the economy. But if inflation occurs on the consumer level, which accounts for two-thirds of growth, watch out.

Many economists look to inflation on the producer level as an indicator that inflation on the consumer level is in the offing. But that's not always the case, according to a researcher from the Federal Reserve Bank of Kansas City.

Todd Clark found that there was little relation between producer and consumer inflation. He looked at inflation between 1977 and 1994 and found that models that attempt to predict consumer inflation which include producer prices don't do a better job than models that exclude that information. In some cases, the model that excludes producer prices, in fact, does a better job of predicting inflation.

The findings of the study led the researcher to conclude that "the production chain only weakly connects the PPI (Producer Price Index-a measure of inflation) to subsequent movements in the CPI (Consumer Price Index-a measure of inflation)."

Bottom line: let the bond traders go nuts the next time the government releases its Producer Price Index but don't take it to be an indicator for inflation on the consumer level.

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