Inflation? What Inflation?

In September, the Producer Price Index (PPI) fell 0.6% on a headline basis, while excluding food and energy it was down 0.1% for the month. This is in fairly distinct contrast to August, where the PPI rose 1.7% on a headline basis and 0.2% for the core.

Year over year, producer prices for Finished goods are down 4.8%. In August, they were down 4.3% year over year. These numbers, along with the low readings from the CPI last week (up 0.2% on both headline and core for the month, headline down 1.3% year over year with core up 1.5%) make it clear that the inflation dragon is sleeping.

The big swing factor was energy, which fell 2.4% on the month after an 8.0% surge in August. That is not likely to last into October given the recent strength in both oil and natural gas prices.

Looking farther up the production chain, prices for Intermediate goods rose 0.2% for the month, down from a 1.8% increase in August. On a year-over-year basis, prices for Intermediate goods are down 11.7%. Prices for Crude goods were down 2.1% for the month, mostly reversing the 3.8% increase in August. (Here's a trick to keep Finished, Intermediate and Crude goods straight: think Bread, Flour and Wheat, respectively.)

On a year-over-year basis, Crude goods are down 31.5%. However, the year-over-year numbers at the Intermediate -- and especially the Crude -- levels are going to show much slower declines in the next few months.

In October of last year, Intermediate goods prices fell 4.2% while prices fo Crude goods tumbled 16.1%. The plunge continued into November, with intermediate prices down 4.8% and crude goods falling 13.1%. This is a key reason why the year over year earnings for firms in the Materials sector, like Nucor (NUE - Analyst Report), Dow Chemical (DOW - Analyst Report) and Freeport McMoran (FCX - Analyst Report) are going to generally look ugly in the third quarter, but will look wonderful in the fourth quarter.

From a broad economic point of view, this just adds to the compelling case for the Fed to keep interest rates low, and possibly even extend its unconventional quantitative easing policies. The danger is a recovery that is lackluster and falters, not that the economy overheats and inflation gets out of control.

The graph below shows that the year-over-year change in producer prices at all three levels of production are near their lowest levels of the last 40 years.  Getting the economy moving again is job number one; the Fed (and investors) should not be worrying about the non-existent threat of inflation.