Rate cut expectations dealt a heavy blow! US July PPI surprises on the upside, rising 0.9% month-on-month, marking the largest increase in three years.

Just now, the market suffered a major blow to the interest rate cut expectations for the remaining time of the year by the Federal Reserve. The US PPI inflation data released on Thursday evening Beijing time showed that the US July PPI unexpectedly accelerated, marking the largest increase in three years, indicating that businesses are passing on higher import costs associated with tariffs. As the Trump administration's tariff policy gradually begins to have a significant impact on inflation, US CPI, PPI, and PCE inflation data may be heading towards a new round of upward trajectory. The latest economic data shows that in July, US PPI inflation accelerated to the largest increase in three years, indicating that businesses are gradually starting to pass on tariff costs, but they have not completely absorbed the higher import costs associated with tariffs. PPI usually reflects price changes in advance compared to CPI, which also means that the upward trend of PPI, CPI, and PCE inflation data is far from over, as Trump's tariff policy is sure to bring about a much more significant inflation heating effect than now. The latest report released by the US Bureau of Labor Statistics shows that in July, the US Producer Price Index (PPI) rose sharply by 0.9% compared to the previous month, marking the largest monthly increase since June 2022, when US consumer inflation (CPI data) hit a near-term high. The PPI also increased by 3.3% year-on-year. Both the month-on-month and year-on-year increases in July's US PPI far exceeded market expectations. The market expected a month-on-month increase of only 0.2% for PPI, while the market expected a year-on-year increase of only 2.5%. Compared to the significant warming seen in June, the June PPI saw no growth on a month-on-month basis. In terms of core PPI indexes excluding energy and food, both the month-on-month and year-on-year growth rates exceeded market expectations. Core PPI increased by 0.9% month-on-month in July, compared to an expected 0.2%, with a previous value of 0; Core PPI increased by 3.7% year-on-year, compared to an expected 2.9%. The PPI statistics show that in the previous month, the cost of producer services in the US surged by 1.1% month-on-month, marking the largest increase since March 2022. Under services, profit margins for wholesale and retail traders in the US jumped by 2% month-on-month, with producers of machinery and equipment wholesale leading the way. The core goods PPI price index excluding food and energy rose by 0.4% month-on-month. The report shows that with Trump's tariff policy becoming clearer, despite relatively weak demand in the first half of the year, US businesses are still actively adjusting prices for goods and services to help offset the higher costs associated with US tariffs. After the release of the US PPI inflation data, the futures of the three major US stock indexes fell, while the yields of US government bonds moved upward due to the significant increase in inflation expectations and the major decline in interest rate cut expectations. The extent to which US businesses pass on tariff burdens to consumers will be crucial in defining the interest rate path of the Federal Reserve. Although Federal Reserve officials generally expect import tariffs to significantly drive up inflation in the second half of the year, there is disagreement on whether this will be a one-time adjustment or a more enduring inflation phenomenon. Some officials are even starting to worry about a macroeconomic situation in which the Federal Reserve's monetary policy is caught in a dilemma stagflation. Earlier consumer price data (CPI) this week pointed to mild price pass-through in July, while the US non-farm labor market is entering a period of slower growth, with Federal Reserve officials widely expected to cut lending costs at next month's monetary policy meeting. However, the much stronger-than-expected increase in PPI inflation data may cause some Federal Reserve FOMC monetary policy decision-makers to hesitate on whether price pressure is re-emerging. "The question facing Federal Reserve policy makers, which remains unresolved, is how much of these price increases will be absorbed by wholesalers, retailers, and resellers," said Carl Weinberg, chief economist at High Frequency Economics, in a report. "This PPI inflation report undoubtedly strongly confirms the rationality of the Federal Reserve's long-term wait-and-see stance on monetary policy changes." Economists closely monitor the PPI report because some components are used to calculate the Federal Reserve's preferred inflation gauge the core personal consumption expenditures (core PCE) price index. Although the PPI data shows weakness in the healthcare category, the prices of air travel services and investment management have risen significantly. The latter is largely due to the recent record highs in the US stock market being within market expectations. Labor Department data shows that food prices account for about 40% of the final goods cost increase, mainly due to a sharp increase in vegetable prices. The lower volatile core PPI index excluding food, energy, and trade services recorded the largest monthly increase since 2022 on a month-on-month basis. The PPI report shows that the cost of "intermediate demand processed goods," which reflects prices in earlier stages of production, unexpectedly jumped by 0.8% the largest increase this year, mainly driven by diesel fuel. Ben Eilers, senior economist at Nationwide, said in a report, "Although businesses have borne the brunt of the tariff cost increases so far, rising import costs are increasingly squeezing profit margins. We expect that in the coming months, tariffs will further be passed on to consumer prices, and the inflation rate may climb slightly in the second half of 2025." Significant cooling of Fed rate cut expectations after unexpected PPI inflation data After the release of the higher-than-expected PPI inflation data, traders in the interest rate futures market significantly cooled their expectations for Fed rate cuts. Prior to the PPI release, due to extremely weak July non-farm data and mild inflation indicated by the CPI data, the interest rate futures market almost priced in a 100% chance of a 25 basis point rate cut by the Federal Reserve in September, and bet that the remaining October and December FOMC monetary policy meetings would also see 25 basis point rate cuts. The August 1st release of non-farm employment data indicated a significant cooling in the US labor market in recent months. Data from the US Bureau of Labor Statistics showed that in July, businesses added only 73,000 jobs, well below economists' expectations of around 110,000; at the same time, the initial figures for non-farm employment in the previous two months were unexpectedly revised downward by nearly 260,000, with a revision rate of up to 90%, unprecedented. The latest unemployment rate rose from 4.1% in June to 4.2%. Therefore, this non-farm data largely pushed traders to heavily bet on Fed rate cuts: pricing in the interest rate futures market showed that traders were betting heavily on the Fed restarting rate cuts, with nearly 100% of bets expecting a 25 basis point rate cut by the Fed next month compared to less than 40% before the non-farm release and betting on at least two rate cuts before the end of the year, even betting on consecutive 25 basis point rate cuts in September and October, followed by a 25 basis point cut in December, totaling three rate cuts of 75 basis points by the end of the year. However, after the much higher-than-expected release of the PPI data, market expectations for rate cuts cooled significantly. The "CME FedWatch Tool" shows a significant reduction in market expectations for a 25 basis point rate cut in September by the Federal Reserve, dropping from nearly 100% to about 80%, while bets on rate cuts in October and December also saw significant reductions, with the current interest rate futures market still pricing in a 25 basis point rate cut in October and a probability of over 60% that there will be no rate cut in December. With inflation reaching an upward trajectory under the stimulation of Trump's tariff policy, will stagflation emerge? Before the release of the PPI data, a research report from Morgan Stanley on Wall Street showed that historical experience indicates that the comprehensive inflation impact of tariff transmission still requires a lag of 3 to 5 months, so a series of upcoming economic data to be announced is crucial for the September meeting decision. The institution stated that although the market currently sees the Fed's rate cut in September as almost certain, there are still many variables to observe. Morgan Stanley still maintains a cautious expectation of no rate cuts by the Federal Reserve throughout 2025. A research report released by Bank of America this week showed that even if CPI increases moderately by 0.1% month-on-month, CPI is expected to rise to around 2.9% year-on-year by the end of the year, significantly higher than the 2.3%-2.4% levels in the first half of the year. The economists at Bank of America also stated that if the Federal Reserve restarts the rate-cutting cycle, any rate cuts this year may take place against the backdrop of rising year-on-year inflation. Bank of America pointed out that this combination of "rising inflation and falling rates" is quite rare. Since 1973, the probability of the Federal Reserve cutting rates when inflation is rising has been only 16%. Bank of America stated that if the analysis is done using the core PCE price index, which the Federal Reserve prefers, the upward trend in the year-on-year inflation indicator may appear even earlier. In addition, the effective "reciprocal tariff" policy has also brought supply-side price increase risks to US inflation in the coming months. The strategy team at Deutsche Bank believes that the US economy is facing the risk of stagflation caused by supply-side shocks. The institution recommends shorting 10-year US Treasury bonds. The strategists at Deutsche Bank stated that the upward adjustment in tariffs and the tightening of immigration policies by the Trump administration will have negative supply-side impacts on the US economy, pushing up inflation while weakening economic growth, but it is not expected to lead to an economic recession. The institution expects the core CPI inflation to rise by about 0.5 percentage points year-on-year in the coming months due to the tariff impact, significantly higher than market consensus and current pricing. The institution also predicts that future core CPI month-on-month increases will be in the range of 0.3% to 0.4%, posing significant upward risks compared to market consensus and pricing trends.