The wrong kind of good news on prices

The wrong kind of good news on prices

America's producer prices were flat in July. The relief is cosmetic — and it reveals more about the Federal Reserve's credibility than about inflation.

THE FIRST glance at America's July report on producer prices looked like a quiet win. The index that tracks what factories, farms and service firms charge for their output was flat for the month, against forecasts of a 0.2 per cent rise. After a spring in which prices at the factory gate were the scariest number in official statistics, the print seemed to say that the war-driven burst of inflation was finally draining away. The second glance suggests the opposite.

Headline producer prices are still 4.7 per cent higher than a year earlier, down from 5.5 per cent in June and a touch below the 4.9 per cent forecast — more than double the Federal Reserve's target of 2 per cent. Strip out the volatile bits, and the picture turns worse, not better. The Bureau of Labor Statistics' cleanest underlying gauge, final demand excluding foods, energy and trade services, rose 0.4 per cent in July and has risen 4.7 per cent over the past year, in step with the headline itself. The flat print is relief in the wrong places.

The arithmetic explains the deception. July's decline was a food-and-energy affair: gasoline fell 5.7 per cent, energy 3.1 per cent and food 0.9 per cent. These are precisely the prices that spiked in March, when the strikes on Iran began, and they were always destined to ease once supply chains stabilised. This is not disinflation; it is the reversal of an oil-shock spike. The prices that producers actually control marched upward instead. The services slice of the index rose 0.2 per cent, dragged higher by a 6.5 per cent jump in the fees that fund managers charge for running portfolios. Construction costs rose 2.2 per cent. Even within goods, motor vehicles and equipment edged up. Whatever the headline says, there is no shortage of pricing power left in the American economy, and it now lives in services, where no global supply chain can arbitrage it away.

The persistence is not mysterious. Producer prices are simply where this cycle's supply shocks land first. This is not a demand boom in disguise; it is the collision of two events. The first is the energy disruption of the Iran war, which pushed oil past $100 a barrel in July and still leaves energy prices at the consumer level up by double digits year on year. The second is tariff policy. Restored import levies function, from an economist's point of view, as a tax on domestic producers, and the factory gate is exactly where such a tax is recorded first. The earlier surge in producer prices was widely attributed to the war and to the tariffs imposed by the Trump administration. Washington has been feeding inflation with one hand while deploring it with the other.

The gap between prices at the factory gate and the checkout counter matters because producer prices are the upstream end of the inflation system. Consumer prices rose only 3.4 per cent in the year to July, and their core measure, stripped of food and energy, rose just 2.5 per cent. The comparable core index for producers rose 4.2 per cent. The two baskets are constructed differently, so the absolute spread is not an apples-to-apples measure; its direction still tells you who is absorbing the cost. Someone is swallowing the difference between a 4.7 per cent rise at the factory gate and a 3.4 per cent rise at the register. That someone is either business margins, which will show up later in weaker profits and lower investment, or consumers, whose bills have not yet caught up with producer costs. A flat headline did not make the supermarket safe.

It is against this background that the Federal Reserve's recent behaviour deserves scrutiny. At the end of July the committee left the federal-funds rate at 3.5-3.75 per cent, doing so by a vote of 9 to 3, with three regional-bank presidents openly arguing for an immediate increase. Its chair, Kevin Warsh, an appointee of President Donald Trump who was expected to deliver the friendlier policy the White House wanted, has gone further and abandoned the forward guidance on which central banks rely to anchor expectations. A central bank that will not say where it thinks rates are heading leaves markets to guess.

And guess they do. A year that began with investors betting on rate cuts has become a debate about raising them, as core inflation and the war's energy shock flipped expectations. Futures positions have swung from barely one-in-ten odds of an increase in mid-July to four-in-five on the eve of the decision, and back to about two-in-five after last week's calmer inflation data. Ahead of the meeting on September 15th and 16th, the market assigns near-even odds to a hold. Even the committee cannot agree with itself: in June, a majority of its members pencilled in at least one increase during 2026. When the central bank cannot say with confidence where rates are heading, the market must price both worlds.

The professionals illustrate the muddle. J.P. Morgan's wealth-management strategists expect a quarter-point increase in September to repair the central bank's credibility; MUFG, a Japanese bank, expects rates to stay put for the rest of the year, with any easing pushed into early 2027. More important than the split is what the bond market has done with it. After the July hold, yields on America's longest-dated government bond rose to their highest level since 2007 — the market raising the price of insurance against a central bank that lets inflation run. That is the danger the hawks have been pointing at all year. The risk is not that a future increase will hurt; it is that investors stop believing one will ever come. A central bank that cut for a year, then hesitated at the first brush with a trade war and an energy shock, is asking markets to take a leap of faith. Many are declining.

Politics makes the clean response harder. The midterm elections are months away, and polling shows that many Americans are unhappy with the economy and blame the administration's policies. Yet this is the same administration that re-imposed tariffs of the sort now showing up at the top of the producer-price report, and that wants the Federal Reserve to make their effects disappear. The tools that would actually help — removing the levies, letting supply chains normalise, allowing the central bank to take a measured step if underlying prices persist — are precisely the ones that prove hardest in an election season. Politicians are rarely rewarded for admitting that a visible tariff is a hidden tax, and that the bill lands first on producers, who pass it down the line.

None of this means July was bad news. A flat month at the factory gate beats a hot one, and the energy-driven parts of the index will exert downward pressure for a few more months. The narrow measure of underlying producer inflation, however, accelerated in July. That is not the profile of an economy gliding back to the Fed's 2 per cent target; it is the profile of an economy with a services-price problem, a lingering oil shock and a central bank under political siege. Read the flat print as a reprieve, not a victory.

The sensible programme is banal in its components and awkward in its politics: strip away the tariffs that function as a tax on producers; let the war-related energy shock wash through the indices; and allow the Federal Reserve to take the credibility-preserving step — a cautious increase — that its own regional presidents have demanded, should services inflation persist. The genuine threat to American prosperity is no longer the price of petrol. It is the growing possibility, already visible in bond yields, that the institution charged with controlling prices no longer has the freedom, or the will, to try.