Producer Prices Stable

Of the three major economic reports released today (see also: "Increasing Starts - NOT Good News" and "Slack in the Industrials System"), the report on producer prices was by far the best news. Overall, producer prices for finished goods increased at a rate of just 0.2%. A big 2.9% increase for Energy was offset by a 1.6% decline in finished food prices. This left the change in core (ex food and energy) producer prices down 0.1%.

The scare about outright deflation, which looked very possible last fall when the overall PPI fell 2.6%, 2.7% and 1.8% in October through December, has passed. On the other hand, inflation has not started to rear its ugly head. On a year-over-year basis, producer prices are still accelerating to the downside, now at -5.0% vs. 3.7% in April and 3.5% in May. However, that is due to very large increases a year ago rolling off.

As incredible as it may seem, it looks like the Fed got it just right last fall. Monetary policy always acts with pretty long lags, and the price movements we are seeing now are the result of the monetary actions that were taken in the fourth quarter of last year. Given the unprecedented turmoil back then, applying exactly the right amount of liquidity to put out the forest fire of deflation without unleashing a flood of inflation is a very significant (and perhaps very lucky) achievement.

We will see tomorrow if the same holds true at the Consumer (CPI) level. If the CPI is also stable, it means that the Fed has more leeway to keep monetary policy very accommodative and not risk choking off any hopes of a recovery.

Further up the production chain, intermediate goods increased 0.3%. This was the first increase at that level after nine straight months of declines. The always much-more-crude level (essentially commodities) saw a 3.6% increase in the month, following a 3.0% increase in April. I would not be too worried about that since the declines in prices at that level from August through March were absolutely brutal. Even with the back-to-back increases, crude goods are still down 41.1% year over year. Intermediate goods are down 12.5% year over year.

Given the slack in the system -- for example, the record amount of idle industrial capacity and the 9.4% (and rising) unemployment rate -- it is very hard to see how the wage side of a wage price spiral could take hold. However, given the amount of liquidity injected into the system, there are many investors who are worried about the direction of the dollar.

Given that other major currencies all have their own issues, money might just flow back into commodities as a potential store of value. China has been importing commodities recently at levels that far exceed any current increase in overall production of goods made from those commodities. They also far exceed any plausible near-term production increase.

For example, the chart below (from http://macro-man.blogspot.com/2009/06/china-syndrome.html) shows that China’s recent copper imports are almost twice their average level since 2002. If you follow the link, you will see that copper is not an isolated instance, but just one of many commodities that China has started to stockpile in a very big way.

While this is good news for big miners like Freeport McMoran (FCX - Analyst Report) it could mean that China is getting tired of piling up ever-increasing mountains of T-notes and wants a better store of value than the dollar. This could then be the avenue through which inflation does rear its head.

However, without wages keeping pace, it would simply mean lower real wages for Americans. Holding some commodity-oriented firms in your portfolio, be they precious metal firms like Barrick Gold (ABX - Analyst Report), base metal firms like Vale S.A. (VALE - Analyst Report) or an oil firm like Exxon (XOM - Analyst Report) might be a good way to hedge against that possibility.