Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching Energy Inflation Like a Hawk
Transcript
- Lucas: So the April PCE came out Thursday, and the headline number was pretty much exactly what everyone expected — core inflation running at 3.3 percent on an annualized basis. That's the same sticky number we've been seeing for months. Luna: Same number, but the market didn't flinch. The ten-year yield actually fell a bit — it's at 4.45 today, down almost a percent over five days. Lucas: Right, and that's the interesting part. Normally a 3.3 percent core print would spook the bond market, especially with the fed funds rate stuck at 3.64. But the market is looking past the headline and focusing on the components. Luna: And the big component this month is energy. The Iran war has pushed gasoline and heating costs way up. CNBC had that headline Friday — average household paying an extra 450 dollars on gas and energy. Lucas: Four-fifty a year, which is meaningful for low- and middle-income households. But here's what the Fed is actually debating behind closed doors: how much of that energy spike bleeds into core inflation. Because if it's just a relative price shift — people pay more at the pump, spend less elsewhere — that's a one-off. The Fed can look through it. But if it's feeding into expectations, into wage demands, into services inflation, then they have to act. Luna: And Fed governor Goolsbee was on CNBC Thursday saying energy inflation has been more persistent than expected. That's notable because he's usually one of the more dovish voices. Lucas: Exactly. If Goolsbee is worried, the hawks are probably howling. And we also heard from Kashkari — he said the inflation fight takes priority because the labor market is 'in decent shape.' That's a clear signal that the Fed is leaning toward holding at 3.64 for a while longer. Luna: But let's talk about that 'decent shape' line. The labor market is fine — unemployment is low, job openings are steady. But wage growth has been picking up, especially in blue-collar sectors that are seeing ai driven demand. If workers start demanding higher wages to offset energy costs, that's the kind of second-round effect the Fed fears. Lucas: That's the classic wage-price spiral concern. And the data we have now — the April CPI was 332.4, up from 330.29 in March. That's about 0.6 percent month-over-month, which is too fast for comfort. The ten-year breakeven inflation rate sits at 2.39 percent — basically flat, but still above the Fed's 2 percent target. Luna: So expectations are anchored, but barely. And the longer inflation runs above target, the more that anchor starts to drag. Lucas: Look, we spend a lot of time on this podcast talking about the bond market, the yield curve, the data. If walking through the economy with us has made something click for you, we'd love it if you'd consider supporting the show. It's listener-supported, no ads, and every bit helps. You can find us at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to keep this conversation going without any commercial breaks. Appreciate anyone who chips in. Lucas: So back to the energy question. The ten-year yield is 4.45, the two-year is at 3.59. That's a spread of about 86 basis points — a pretty steep curve, which usually signals the market expects either growth or inflation or both to pick up. But the Fed is holding at 3.64, which is below the ten-year. That's an inverted stance in real terms. Luna: And that creates a political problem for Chair Warsh. He's only been in the job since February, and already he's facing pressure from both sides. The doves say the economy is softening — consumer sentiment hit a record low, the Iran war is a drag — so they want a cut. The hawks say inflation is still too high, cut too soon and you lose credibility. Lucas: Warsh's own background suggests he'd lean hawkish. He was a bond guy before becoming a Fed governor. He knows the vigilantes are watching. But he also knows that if he raises rates while energy prices are spiking, he could tip the economy into recession. Luna: So what's the way out? Do they just sit at 3.64 until the Iran situation resolves? Lucas: That's the baseline expectation. The fed funds futures market is pricing no move at the June meeting and maybe one cut by December. But the risk is that if energy keeps climbing — and there's no sign of a ceasefire yet — the Fed may eventually have to hike. Not because core inflation is accelerating, but because inflation expectations might break higher. Luna: And that's the thing with the breakeven at 2.39. It's not moving much now, but if oil spikes another 10 percent, it could. And once expectations become unanchored, getting them back is painful. Lucas: That's the lesson of the 1970s. The Fed under Arthur Burns kept looking through energy shocks, and inflation became entrenched. Paul Volcker had to crush the economy to break it. Warsh knows that history. I suspect he'd rather err on the side of doing too much than too little. Luna: But doing too much right now — with the Iran war, consumer sentiment in the tank, and the housing market already weak — that's a tough sell. The political pressure on the Fed is enormous. Lucas: No question. And that's why the ten-year yield is stuck at 4.45. The bond market is saying: we don't think you're going to hike, but we don't think you're going to cut either. So we'll just sit here and collect the carry. It's a waiting game. Luna: And the winner of that waiting game depends on what happens in the Middle East. If energy prices come down, the Fed can coast. If they keep rising, the Fed may have to choose between its inflation mandate and its employment mandate. Lucas: That's the tension at the heart of monetary policy right now. The data is giving conflicting signals — core inflation sticky but not accelerating, the labor market solid, but consumer confidence cratering. And the wildcard is an exogenous energy shock that the Fed can't control. Luna: It's almost a return to the 1970s playbook, but with a much more independent Fed — at least in theory. Lucas: Right. And with a Chair who understands bond markets better than most. Kevin Warsh was a partner at Morgan Stanley and served as a Fed governor during the financial crisis. He's seen how quickly market confidence can evaporate. My guess is he'll hold the line at 3.64, keep rhetoric hawkish, and wait for either energy to subside or the economy to weaken enough to justify a cut. Luna: So next meeting — June 16 and 17 — we're likely looking at another hold, with a statement that emphasizes inflation vigilance. And maybe a few dissents from the doves. Lucas: Exactly. And we'll watch the ten-year yield for clues. If it breaks above 4.5, the market is starting to price in a hike risk. If it falls below 4.3, the market is betting on a cut. Right now it's in no-man's-land. Luna: Which is exactly where the Fed wants to be — not forced into a corner, but not comfortable either. Lucas: I think Warsh would say that's the new normal. A Fed that can't afford to be complacent, but can't afford to overreact either. The bar for a move — in either direction — is very high.