Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Core PCE at 3.4 Percent What the Feds New Inflation Signal Means
Transcript
- Lucas: So the May Core PCE reading came in at 3.4 percent, year over year. That's the highest since October 2023, and it's the Fed's preferred inflation gauge. Luna: And this comes just weeks after the Fed's dot plot showed they're still projecting rate cuts this year. How do you square that? Lucas: That's exactly the tension. The Fed's own projections from the June meeting had core PCE ending 2026 at 2.8 percent, but we're already at 3.4. So either they think inflation will cool sharply in the second half, or they're willing to tolerate higher inflation than they've been saying publicly. Luna: Or they're just wrong again. Because the track record here is not great. Lucas: Right. And that's actually the most honest read. In the press conference after the June FOMC meeting, Chair Warsh was asked about the Fed's forecasting ability, and he basically said — and I'm paraphrasing — that the models have been struggling with structural shifts in the economy. He didn't defend the forecast. He said they're learning. Luna: That's a pretty big admission from a Fed chair. I mean, if the models can't predict inflation, what's the basis for the rate path? Lucas: Right, and this goes back to something we've talked about before — the Fed's inflation forecasts have consistently undershot since 2021. They kept calling for transitory inflation, then for a quick return to 2 percent, and now they're projecting a gradual decline that hasn't materialized. Core PCE has been stuck between 2.8 and 3.4 for over a year. Luna: So if the forecast is unreliable, what's actually driving the rate decision? Is it the data, or is it some other framework? Lucas: I think it's a mix of data dependence and a kind of strategic patience. The Fed doesn't want to overreact to one hot inflation print, especially when some components — like used car prices and airfares — are volatile month to month. But the 3.4 percent number isn't just one month. It's the third consecutive month above 3.2. Luna: Yeah, and services inflation ex-housing has been particularly sticky. That's the part that's hardest for the models to capture, because it's tied to wages and expectations. Lucas: Exactly. And that's the core of the forecasting problem. The models were built for a world where inflation was mostly driven by demand shocks and the output gap. Now we have supply chain shifts, labor market tightness that persists, and housing inflation that's slow to roll over because of how rents are measured. Luna: So the Fed is flying partly blind. But they still have to make a decision. What's your read on the next move? Lucas: I think they'll cut in September, assuming the data doesn't get worse. Here's why: the Fed has a dual mandate, and the labor market is showing cracks. The unemployment rate ticked up to 4.1 percent in May, and job growth is slowing. If they wait too long to cut, they risk tipping the economy into recession. Luna: But if they cut with inflation at 3.4 percent, doesn't that damage their credibility? I mean, they've been saying 2 percent is the target. Lucas: Credibility is a concern, but I think they've already started to re-frame the target as a medium-term goal, not a rigid line. Warsh said in his press conference that they're 'committed to returning inflation to 2 percent over time,' which gives them flexibility. And the market is already pricing in cuts. Luna: The market's been pricing in cuts for a year, and they keep getting pushed back. But maybe this time is different. The 10-year breakeven inflation rate has actually fallen to 2.20 percent, which suggests bond investors think inflation will moderate. Lucas: That's a key point. The breakeven rate has been declining even as actual inflation stays elevated. So the bond market is betting that the current inflation spike is temporary, or that the economy will slow enough to bring it down. The Fed might be taking a cue from that. Luna: Or the bond market could be wrong too. But at least it's consistent with the Fed's narrative. Lucas: Yeah, and the Fed's narrative is that the lagged effects of tight monetary policy are still working through the system. They've held rates at 3.63 percent effective since April, and the argument is that it takes 12 to 18 months for rate hikes to fully impact inflation. So maybe the slowdown is coming. Luna: But if it hasn't shown up by now, after the most aggressive tightening cycle in decades, you have to wonder if the transmission mechanism is weaker than it used to be. Lucas: That's the big question. Some economists argue that with less variable-rate debt in the economy, and with households having locked in low mortgage rates, monetary policy isn't as potent as it was in the 1990s. If that's true, the Fed might need to keep rates higher for longer, or accept a higher inflation target. Luna: And that would be a huge shift. But Warsh hasn't signaled that publicly. Lucas: No, he hasn't. And he probably won't until the data forces his hand. But the fact that they're still projecting cuts while inflation is above 3 percent suggests they're already operating with a de facto higher target, even if they won't say it. Luna: So for the listener who's trying to figure out what this means for their portfolio or their mortgage, what's the takeaway? Lucas: I'd say expect a cut in September, maybe a quarter point, but don't expect a rapid easing cycle. The Fed will move cautiously because they don't want to reignite inflation. And if you're locking in a mortgage, the 10-year Treasury at 4.37 percent is probably a reasonable level — it might not drop much further. Luna: Yeah, the bond market is already pricing in a gradual path. So the real story here isn't just the 3.4 percent number — it's the Fed's response function. They're showing they'll cut even with inflation above target, as long as the labor market softens. Lucas: Exactly. And that's the new framework: they're prioritizing employment over inflation at the margin. It's a subtle but important shift. Luna: You know, it's funny — we spend all this time analyzing Fed statements and data, and it's because the Fed's decisions affect everything from mortgage rates to job security. And this show exists to make sense of that without any ads or noise. Lucas: That's right. We deliberately keep the Fexingo shows ad-free because we think this kind of analysis should be straightforward and accessible. If you find value in that, and you want to support the work, you can at buy me a coffee dot com slash fexingo. It's a simple way to keep us independent. Luna: Yeah, no pressure at all. We're grateful for everyone who listens. Now back to the inflation picture — one thing I'm watching is the upcoming CPI report for June, due out in mid-July. If that shows a deceleration, it'll give the Fed more cover to cut. Lucas: Absolutely. And the other wildcard is the global environment. The situation in the Strait of Hormuz is fragile, and oil prices could spike if things escalate. That would push headline inflation up and complicate the Fed's decision. Luna: So the next few weeks are critical. The Core PCE at 3.4 percent is a flashing yellow light, not a red one, but it means the Fed's path is narrow. Lucas: Narrow, but navigable. The key is whether inflation starts to moderate in the second half as the Fed expects. If it doesn't, the rate cut story could fall apart. But for now, the market and the Fed seem to be aligned on a gradual easing path starting in September. Luna: We'll see. It's never that simple with the Fed. Lucas: It never is. And that's why we'll keep watching.