APPENDIX 3: INTERPRETATION OF THE STAGE OF PRODUCTION INDEXES
Introduction
Background
The use of the SOP indexes

INTRODUCTION

1 This appendix provides a description of the use of the Stage of Production (SOP) Indexes.


BACKGROUND

2 The name SOP refers to the stages before a product is deemed final and is then either consumed, used as capital or exported.

3 In the case of the SOP indexes, the last three stages of production are represented where products may be assigned to any, or all three stages. As discussed in Chapter 3: The future suite of Producer and International Trade Price Indexes the naming of the stages has been reviewed and will be renamed to better reflect the relationship of the stages of production to final demand. Accordingly, the ABS will use the following terminology:

• Stage 3 (Final) will become Final Demand – Products consumed as Final Demand;
• Stage 2 (Intermediate) will become Intermediate Demand – Products consumed as inputs into the production of Final Demand; and
• Stage 1 (Preliminary) will become Preliminary Demand – Products consumed as inputs into the production of Intermediate Demand.

4 The SOP indexes show the impact of price changes of products used in different stages of production in the same time period. For example, the price change observed for the manufacture of aluminium ingots will be reflected concurrently in the Intermediate demand stage of production index (previously referred to as Stage 2) and in the Preliminary demand stage of production index (previously referred to as Stage 1).
THE USE OF THE SOP INDEXES

5 The SOP indexes provide analysts with the potential for economy-wide inflation monitoring. Their explanatory power at a disaggregated industry level includes a product's contribution to price change for each stage of production headline measure.

6 At a more aggregated level, the SOP indexes allow comparison of final consumer domestic and final consumer import price inflation contributions, and comparison of final capital domestic and final capital import price inflation contributions. SOP final demand indexes also allows a breakup of price changes between consumer goods (household and government) and capital goods.

7 The graphs below illustrate the price change for the different stages of production indexes from the December quarter 1999 to the December quarter 2011. For ease of reference, they are presented using the current terminology.

8 Graph 1 illustrates that, on average, increases in prices are greater at successively earlier stages of production. During the period 2000 to 2003, Preliminary and Intermediate stage price increases were relatively low. Prices in these two stages then increased dramatically during the period 2003 to 2007, before dropping sharply in 2008 – a result of the global financial crisis (GFC). As the economy came out of the GFC, prices in these two stages resumed their upwards trajectory from 2009 to the present. In contrast, price increases in the Final stage show less volatility. However, there is still a consistent upwards trend in Final stage price levels, but at a consistently lower rate of increase than for the other two stages.




9 Graph 2 illustrates the price indexes at all three stages of production. There is no discernible visual lead–lag relationship between stages and time periods. The graph also highlights the volatility of price changes in the different stages of production, with Preliminary stage prices more volatile than Intermediate stage prices, which in turn are more volatile than Final stage prices.


10 Graph 3 illustrates that from December quarter 1999 to December quarter 2011, the principal sources of price level increase were domestic. All three stages of domestic production provided similar levels of inflationary pressure. In contrast, Import price levels demonstrated a lesser impact. The highest Imported price level change came from Preliminary stage imports, reflecting a greater exposure to international raw material commodity prices. Intermediate stage imports were under less pressure, while Final stage imports showed a decline over the decade.




11 Graph 4 illustrates that all SOP indexes experience predominantly positive inflationary pressures, though Preliminary and Intermediate stages are more likely than the Final stage to see deflationary quarters. Preliminary and intermediate stages both had a large price increase spike prior to the global financial crisis (GFC), immediately followed by a large deflationary spike during the GFC itself. Since the GFC, price increase pressures have returned to the patterns seen in the period 2003 to 2006.



12 Graph 5 illustrates that during the period 1999 to 2011, the quarterly Final stage consumer price changes have been more volatile than the Final stage capital price changes. Final stage consumer price levels show frequent periods of price decrease, along with regular quarterly increases of 1–2%. Prior to the global financial crisis (GFC) in 2008, Final stage capital prices were increasing at approximately 1% per quarter. The GFC saw a decrease in Final stage capital price levels, with a subsequent post GFC return to a pattern of price level increases, but at a lower level than prior to the GFC.




13 SOP consumer and capital import price indexes also facilitate comparisons of price changes with respect to exchange rate variations from series such as the United States dollar (USD) and Trade Weighted index (TWI) (see Graph 6). This provides some indication of the influence of exchange rates on domestic producer inflation.



14 The current SOP also provides disaggregation by domestic and imported inflation. However, imports price change information is based on goods prices only. Price changes for imports and exports of services are not incorporated within the ITPIs. In the medium term International Trade in Services price indexes are scheduled for inclusion into the ITPIs. Issues of scope expansion are more fully addressed in Chapter 4: Quality improvement and coherence of the Producer and International Trade Price Indexes.

15 From their inception, there was an expectation that the SOP indexes would provide a leading relationship to the Consumer Price Index (CPI). ABS research has shown this relationship not to be clearly apparent, with a contemporaneous relationship existing for all three SOP indexes and the CPI. This signals that the transmission of price change may be far more rapid than can be measured by a quarterly index, or that businesses operate in a more fluid way, expanding and contracting margins to compensate for business cycle influences. The lack of a leading relationship may be influenced by:

• The productivity effects at the next stage of production which allow input product price increases to be absorbed;
• The price change influence of primary inputs such as labour which may dominate other input product prices;
• The return on investment effects where capital has been consumed/depleted to offset input product price increases;
• The absorption of inflation costs by producers and/or retailers reducing gross operating surplus (profits) to avoid losing competitiveness in the market place;
• The restraint on price increases created by contractual fixed price agreements;
• The influence of “menu cost” effects where the cost of changing price lists, price labels, etc is greater than the actual price rise itself, causing producers and/or retailers to absorb the price increases; and
• SOP indexes coverage of industries.

16 These and other possible reasons are addressed in various European Union and academic research papers on “sticky prices”.