Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How the Fed Is Reading the May CPI Spike
Transcript
- Lucas: So the May CPI report landed last week — headline annual inflation at 4.2 percent, highest in three years — and obviously the financial press went straight to the eye-popping number. But what the Fed actually cares about in this report is a lot more specific, and I think the market may be misreading it. Luna: Yeah, the headlines were rough. But you're saying the Fed isn't panicking? Lucas: Not exactly panicking, but they're definitely paying close attention to a couple of subcomponents. The one that jumps out to me is core services excluding housing — that's the category the Fed has been watching as a measure of domestically generated inflation. In May, that category rose 0.4 percent month over month, which is a step up from the prior months. Luna: Right, that's the part that's sticky. Housing costs are still elevated, but they're trending down gradually. The services ex-housing is the real puzzle. Lucas: Exactly. And then there's the goods side — used car prices jumped more than 2 percent in May alone. That's partly tariff-related and partly a supply disruption from the Iran conflict affecting shipping routes. The Fed's models might treat that as transitory, but if it persists, it feeds into inflation expectations. Luna: And we saw the 10-year breakeven inflation rate tick up to 2.31 percent. That's not alarming, but it's creeping above the Fed's target. Lucas: Right. The breakeven is a market-based measure, so it's reflecting what bond traders expect for average inflation over the next decade. 2.31 percent is only slightly above target, but the direction matters. If it keeps climbing, the Fed will have a harder time justifying rate cuts. Luna: And the Fed funds rate is at 3.63 percent effective, so real rates are still positive but not massively restrictive. Do you think this CPI print changes the neutral rate debate we talked about a couple episodes ago? Lucas: That's the million-dollar question. The neutral rate — or R-star — is the rate that neither stimulates nor restrains the economy. If inflation stays stubborn, the neutral rate might actually be higher than the Fed previously estimated. Some Fed speakers have floated numbers around 3 percent for the nominal neutral rate. If that's true, the current fed funds rate isn't that far above neutral, meaning policy isn't as tight as it seems. Luna: So the market might be pricing in rate cuts that the Fed can't deliver without reigniting inflation? Lucas: That's the risk. The futures market is still pricing in about two quarter-point cuts by the end of the year. But after this CPI print, I think the Fed will want to see at least two or three more months of data before they signal any easing. They cannot afford to repeat the mistake of 2021, calling inflation transitory too early. Luna: And the ECB hiked rates last week for the first time since 2023, largely because of energy cost spikes from the Iran situation. That puts the Fed in an interesting position — they're not forced to hike, but they can't cut either. Lucas: Exactly. The ECB move actually makes the Fed's job a little easier in one sense: it takes pressure off the dollar. If the ECB hadn't hiked, the dollar would have strengthened more, which would tighten financial conditions. But the broader point is that central banks globally are still fighting inflation, and the Fed is not in a position to diverge too much. Luna: So what's your takeaway for listeners? What's the one concrete thing from this CPI report that an investor or a business owner should keep in mind? Lucas: I'd say: watch the core services ex-housing number over the next few months. If that stays above 0.3 percent month over month, the Fed is on hold for the rest of the year. If it drops back to 0.2 percent or lower, then a cut in September or December becomes plausible. The headline 4.2 percent is noisy — the Fed looks through energy and food. But services inflation is the canary. Luna: That's really helpful. And speaking of canaries — you know, if this podcast helps you make sense of the economic landscape, and it's worth about the price of a coffee to you, there's a link in the show notes. It's buy me a coffee dot com slash fexingo. Literally, if today's episode made something click for you, that's the link. Lucas: Yeah, listener support keeps this show ad-free and independent. And we genuinely appreciate it. So back to the data — one more thing I want to highlight is the small-cap index, the Russell 2000, was up over 3 percent in the last five days. That tells me some investors are betting that the Fed will eventually cut, and that smaller companies are leveraged to domestic demand. Luna: Interesting. So there's a disconnect between the bond market pricing in cuts and the equity market rotating into small caps? Lucas: There is. And that disconnect usually resolves one way or the other. Either the economy slows enough for the Fed to cut, and small caps benefit, or inflation stays hot, the Fed doesn't cut, and the rotation reverses. Right now, the data is pointing both ways, so it's a real tug of war. Luna: And that's exactly why the Fed is being so data-dependent. They don't want to pick a side prematurely. Lucas: Exactly. They're going to let the data accumulate. The next big milepost is the May PCE report, which comes out later this month. That's the Fed's preferred inflation gauge. If core PCE comes in hot, the market will have to reprice those rate cut expectations. Luna: We'll be watching. Thanks, Lucas. Lucas: Thanks, Luna. And thanks to our listeners for sticking with us through the weeds.