Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How the Fed Interprets Mixed Inflation Signals in Mid-2026
Transcript
- Lucas: So we're midway through July 2026, and the inflation picture is getting weird. Not alarmingly weird, but the kind of weird that makes you wonder which data point the Fed actually trusts right now. Luna: We've got headline CPI finally declining — down to 332.6 in June from 333.98. But core PCE, which the Fed officially targets, ticked up to 130.1 from 129.67. That's a divergence. Lucas: Exactly. And if you're listening to this show and something's clicked for you about how the Fed thinks, we should mention that we keep this podcast ad-free by listener support. If that model works for you, you can find us at buy me a coffee dot com slash fexingo. No pressure, just letting you know the option's there. Luna: Yeah, it's how we stay independent. And it means we don't have to shoehorn in ads about mattress companies or meal kits. Lucas: Right. So back to that divergence. The Fed's preferred gauge — core PCE — is running above where they'd like. But CPI, which gets more headlines, is falling. The gap is partly about methodology: PCE accounts for substitution effects better, and it's based on business surveys rather than consumer surveys. But there's another factor that's been distorting things. Luna: Import prices from China. The latest report showed they hit their highest since 2008. That's a supply-side shock that's more visible in the CPI basket because it's heavily weighted toward goods. Lucas: Right. Services inflation, which is a bigger piece of PCE, is actually moderating. So the Fed looks at PCE and sees less heat. But goods inflation from China is keeping headline CPI elevated. The Fed has to parse which signal is persistent and which is just a transitory tariff or supply chain blip. Luna: And then there's wholesale prices. June's PPI fell 0.3 percent, mostly on gasoline. That's deflation at the producer level, which should eventually feed through to consumer prices. Lucas: It should. But the pass-through isn't mechanical. Wholesale deflation gives the Fed cover to stay on hold. The fed funds rate is at 3.63 percent, the ten-year yield is 4.60 percent. The curve is still inverted, which historically signals recession risk, but the economy is actually adding jobs. Luna: So the Fed's in a wait and see mode. They don't want to cut too early if core PCE stays sticky, but they also don't want to tighten into a disinflationary trend that's being masked by China import prices. Lucas: That's the nutshell. And the breakeven inflation rate — the market's expectation for inflation over the next decade — is at 2.25 percent, basically right at target. So the market doesn't think the Fed has lost control. But the noise in the monthly data makes the next FOMC meeting a real debate. Luna: What's your read on the dot plot? Last meeting, the median projection was for one or two cuts by year end. Does that still hold? Lucas: If we get another month where core PCE ticks up, those cuts could get pushed into 2027. But if wholesale deflation starts showing up in retail prices, they might move sooner. The wildcard is China. If those import prices stay high, it's a tax on consumers that the Fed can't fix with rate policy. Luna: Right. It's a supply shock, not demand-driven inflation. That's the kind of thing that would put the Fed in a tough spot because raising rates doesn't lower the price of Chinese goods. Lucas: Exactly. So what they're watching is core services ex-housing — the wage-driven components. If that stays contained, they can afford to look through the goods inflation. And so far, that measure has been slowing. The Fed's preferred metric — the Atlanta Fed's sticky CPI — has been drifting down. Luna: The market seems to agree. The two-year yield is at 3.70 percent, the ten-year at 4.60. That's a ninety-basis-point inversion, which is still deep, but it's been stable for weeks. Lucas: Stable inversion is almost a relief after the chaos of early 2023. The bond market is pricing in a soft landing: inflation gradually returns to target, the Fed cuts maybe once, and recession is avoided. But the inversion itself is a reminder that the bond market has been wrong before. Luna: And the Fed has to balance that. They don't want to overstay their welcome at restrictive levels if the economy is actually weaker than the data suggests. Lucas: Which brings us to the real-time data that's harder to capture. The World Cup gave bars and restaurants a boost in June, but the Fed's own Beige Book noted that consumers are flashing warning signs. People are trading down, using credit more. That's the kind of softness that doesn't show up in CPI but does show up in retail earnings and loan delinquencies. Luna: So the Fed is watching both the hard numbers and the anecdotal signals. And right now, the hard numbers are contradictory enough that they're leaning on the anecdotes. Lucas: I think that's fair. Chair Powell has said they're data-dependent, but they also have to interpret the data in context. The context right now is: global disinflation is underway, but China's reopening has created a messy restart. The Fed can't control that, so they wait. Luna: And while they wait, the balance sheet continues to shrink. Quantitative tightening is still running, though at a slower pace. That's another tool they have — they could adjust the pace of QT before touching rates. Lucas: Right. The overnight reverse repo facility has drained significantly, but reserves are still abundant. The Fed has signaled they want to slow QT before reserves become scarce. So there's a potential policy lever they could pull as early as the next meeting, independent of the rate decision. Luna: That's a good point. The market is so focused on the rate path that they sometimes forget the balance sheet. But QT tightening is effectively another rate hike in the background. Lucas: So the bottom line for this episode: the Fed is facing a data puzzle. Headline CPI falling, core PCE rising, wholesale deflation, China import inflation, stable breakevens, inverted curve. The most likely outcome is a hold in September, with language that keeps the door open to a cut later if the disinflation trend reasserts itself. Luna: And for listeners watching the bond market, the ten-year yield around 4.60 percent suggests the market isn't panicking. But if core PCE comes in hot again in July, expect that yield to drift higher and rate cut expectations to get pushed out. Lucas: Exactly. The data cadence over the next month is critical. We'll get July CPI and PCE before the September FOMC meeting. That will set the tone. Until then, the Fed is in listening mode — and so should we be. Luna: Fair enough. I'll be watching the import price report next month especially. Lucas: Same. And as always, if you want to support ad-free economics analysis like this, the link is buy me a coffee dot com slash fexingo. Every bit helps keep the podcast independent. Luna: Alright, next episode we'll dig into the labor market — JOLTS data is coming out, and that's another piece of the puzzle. Lucas: Looking forward to it. For now, keep an eye on those breakevens.