The forerunner of the Producer Price Index was the Wholesale Price Index, which was established in 1902 to track the prices paid by retail stores for the products they would ultimately resell to consumers. The change in name to Producer Price Index in 1978 reflected, as much as anything, a change in focus of this index away from the limited wholesaler-to-retailer transaction to encompass all stages of production. Prices tracked by the original Wholesale Price Index are now largely tracked by the specific producer price index for finished goods, officially named the Finished Goods Price Index.

The Historical Trend

Producer Price Index

While the PPI has generally increased over the decades, it has encountered a modest degree of volatility, more so that the CPI. While deflation is somewhat rare for the CPI, it is more common for the PPI. A relatively significant and steep deflationary decline can be seen in the early 1920s. A less steep, but extended decline can be seen during the early 1930s with the onset of the Great Depression. Other modest declines are also detectable over the years, most associated with business-cycle contractions.

The PPI exhibits a relatively sharp increase in the 1970s, a decade generally marked by high inflation rates of the CPI. Much of the rise in the PPI during this decade can be traced directly to enormous increases in energy and farm product prices. In fact, it was this period of inflation and price instability that prompted a re-examination of the original Wholesale Price Index that led to the development of the current array of producer price indexes.

A Few Notable Uses

• Economic Indicators: Several of the broad composite producer price indexes lend insight into inflation and business-cycle instability. In particular, the producer price indexes for all commodities, for finished goods, and for finished consumers goods tend to foreshadow changes in the Consumer Price Index and the GDP price deflator. An increase (or decrease) in these producer price indexes today are likely to be followed by a comparable increase (or decrease) in the Consumer Price Index and the GDP price deflator a few months down the road. For household, business, and government decision makers such advanced warning can be invaluable.

  For example, the Chairman of the Federal Reserve System occasionally initiates contractionary monetary policy to fight inflation, even though the CPI and GDP price deflator are relatively stable. Such action is often prompted by increases in the PPI that signal possible inflationary increases in the CPI and GDP price deflator. Using the PPI, the Chairman can make a pre-emptive strike and prevent inflation before it emerges.



• Deflators: Like the CPI and the GDP price deflator, the assorted produce price indexes are commonly used to deflate nominal values to real terms, that is, to eliminate inflationary increases of the nominal values.

  Suppose, for example, that Hank Henderson, proprietor of Henderson's Handy Hardware Manufacturing, is concerned with the decline in his business over the past two decades. One reason might be that his hardware prices are out of line with industry-wide prices, a fact that could be obscured by overall inflationary trends. However, by deflating his hardware prices with the Hardware Price Index, Hank can get a better view of why his business might have changed. If the Hardware Price Index has doubled in two decades, but his prices have tripled, then his above-the-industry-average prices might be driving away customers.



• Specific Industry: Industry and commodity specific indexes are also useful for particular markets, for both scholarly and practical reasons. From a scholarly point of view, economists and other researchers regularly use specific producer price indexes to study the sources of price changes in particular markets. Suppose, for example, that an economist wants to study the extent that gasoline prices affect farm product prices. A little statistical analysis performed on producer price indexes for farm products and gasoline might provide an answer. Should this economists feel energetic, then the producer price index for agricultural machinery and equipment can be tossed into the analysis, as well.

  From a more practical point of view, individual firms frequently include producer price index information in long-term contracts to automatically adjust for industry-wide price changes. For example, a newspaper publishing company that has a 10-year contract to buy newsprint might want to include the producer price index for paper in the terms of the contract. Should the industry-wide paper price fall, as reflected in this producer price index, then the newspaper certainly wants to take advantage of the lower price rather than being contractually locked into a higher one. Alternatively, the newsprint supplying company would want to receive a higher price should the industry-wide paper price rise. Both buyer and seller have the incentive to automatically adjust contracted prices with appropriate price indexes.

Measurement

The price data are obtained from information voluntarily reported by a sampling of firms. The firms are randomly selected based on their industry, geographical location, and products produced. Once a firm is selected and agrees to participate, they report prices each month to the BLS on a special form. The process is much like filing an income tax return, except the firm (a) does it monthly, (b) does not have to pay anything, (c) can stop anytime they want, and (d) will not be penalized for making mistakes.

Once prices are collected, they are aggregated and weighted, then transformed into indexes by comparing the weighted aggregates for the current period with the weighted aggregates for a base period. This formula illustrates the derivation of the PPI:

PPI

=

weighted aggregate in current period weighted aggregate in base period

x 100

The PPI always has a value of 100 in the base period because the "current period" and the "base period" are one and the same. As such, "weighted aggregate in current period" is exactly equal to "weighted aggregate in base period." Suppose, for example, that weighted aggregate for the base period (using base period prices) is $68,341. As such, $68,341 divided by $68,341 times 100 is equal to 100.

For other periods, however, the weighted aggregate is not likely to be EXACTLY equal to $68,341, so the value of the index differs from 100. Suppose, for example, that the weighted aggregate for the current period (using current prices) is $69,287. The value of the PPI then becomes:

PPI

=

$69,287 $68,341

x 100

=

101.38