PPI Does Not Signal New Deflationary Trends

October PPI, excluding food energy and trade, was 0.2% MoM against 0.3% expected and 0.4% in September. This was followed by an equity rally based on expectations that it would get the Fed to hike less. The terminal FFR at 4.88% is down from a peak at 5.15% in early November.

I disagree with the markets on 2 counts.

First, inflation trends.

The final demand goods PPI, excluding food and energy, was -0.1% MoM but this was due to a hedonic adjustment in new car prices that is made in October of every year. This adjustment led to a 1.5% decline in the price of new passenger cars. See Chart 1.

In addition, the evolution of the core goods CPI/PPI ratio has not been monotonic (Chart 2). It has increased since the pandemic, seems to be moving back to the pre-pandemic decline, though it is too early to tell. 

The point is that the core goods PPI trend is still up.  Similarly, there is not enough evidence to argue that the core goods CPI is trending down. In my view there are structural reasons for why core goods price deflation is not making a post pandemic come back. These include geopolitical fragmentation and reduced elasticity of global supply, as well as smaller productivity growth in chips manufacturing. The latter reflects the end of Moore Law’s in the 2000, evidenced by slowing chips deflation and, since the pandemic, inflation (Chart 3).

Core PPI services inflation fell 0.1% MoM, led by a 0.5% decline in margins. But as can be seen from Chart 4, there is much less of a correlation between services CPI and PPI than between goods CPI and PPI. For instance, the PPI does not include OER (please see full BLS discussion). In any event, since this year, the CPI/PPI ratio for core services has been rising.

Bottom Line

There is not enough in the PPI data to call for a slowdown in consumer price inflation.

I also disagree with the markets on the Fed reaction function. Even the doves will agree that one data point does not make a trend. In addition, they are likely to go through an analysis of the data similar to mine and likely end up with similar conclusion. Finally, the collapse in the FCI is going to make life very difficult for the doves since they believe that policy tightening gets transmitted through tighter financial conditions. Even without any worsening in inflation trends, the FCI collapse, if it continues, calls for a higher FFR (Chart 5).

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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