Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Can Ignore Consumer Sentiment Right Now
Transcript
- Lucas: Consumer sentiment hit a record low last week. Again. The University of Michigan survey for May came in at 67.2 — that's the second straight all-time low, and it's below even the April print of 68.4. Luna: And yet, the Fed is sitting at 3.64 percent on the effective rate, not moving. The ten-year yield actually dropped 22 basis points this week to 4.49 percent. So either the bond market is wrong, or the sentiment survey is telling a story that the macro data doesn't support. Lucas: Exactly. That's the tension I want to unpack. Because if you just look at the headlines — record-low sentiment, war in Iran, inflation still sticky — you'd expect the Fed to be under enormous pressure to cut. But Chair Kevin Warsh gave a speech two weeks ago where he basically said the central bank is data-dependent, not sentiment-dependent. Luna: Right, and the data they're looking at — core CPI at 335.4, up from 334.17 the month before — is still moving in the wrong direction. The PCE price index, their preferred measure, is at 130.3, up from 129.48 in February. Lucas: So the Fed sees an economy where prices are still rising, albeit slowly, and the labor market is still tight. The unemployment rate is 3.9 percent. Wages are growing around 4 percent year-over-year. That's not a recipe for rate cuts. Luna: But sentiment is supposed to be a leading indicator. If consumers are this miserable, doesn't that eventually show up in spending? Lucas: It should, historically. And maybe it will. But the hard data on retail sales and services spending hasn't cracked yet. The April retail sales report came in positive, albeit soft. And the Atlanta Fed's GDPNow tracker is still showing first-quarter growth around 2.1 percent. Luna: So the question is: why are consumers so glum if spending is still holding up? Lucas: The Iran war is a huge part of it. The sentiment survey's one-year inflation expectations jumped to 5.2 percent in May. That's the highest since 2022. People are reading headlines about energy prices and assuming the worst, even if actual gasoline prices haven't spiked as much as feared. Luna: The ten-year breakeven inflation rate is only 2.40 percent. So the bond market is saying long-run inflation expectations are anchored, but consumers are panicking in the short term. Lucas: Exactly. And the Fed cares more about the bond market's signal than the sentiment survey's, because the bond market puts money where its mouth is. When the ten-year yield drops 22 basis points in a week, that's a signal that the market thinks the economy is slowing enough to contain inflation without further rate hikes. Luna: So the bond market is essentially doing the Fed's work for it. Higher long-term yields earlier in the year tightened financial conditions, and now that they're easing a bit, it's not because the Fed is cutting — it's because the market is pricing in a slower economy. Lucas: Right. And that's the weird place we're in. The Fed is on hold at 3.64 percent, but the effective fed funds rate has been flat since February. The interest on reserve balances is at 3.65 percent. They're not tightening, they're not easing. They're waiting. Luna: Waiting for what, exactly? Core inflation to come down convincingly? Or for something to break? Lucas: I think they're waiting for more data that confirms the disinflation trend is real. The problem is, core CPI is still running at about 3.6 percent annualized. That's above their 2 percent target. And with the war adding uncertainty to energy and supply chains, they don't want to cut prematurely and then have to reverse. Luna: There's also the political dimension. Kevin Warsh was appointed by a Republican president who has been vocal about wanting lower rates. If Warsh cuts too soon and inflation re-accelerates, he loses credibility with the bond market and with his own committee. Lucas: Yeah, the bond vigilante episode from earlier this spring — when the ten-year yield spiked to 5.02 percent in April — that was a warning shot. The market showed it's willing to punish the Fed if it looks like it's losing control of inflation. Luna: And now the ten-year is back down to 4.49 percent, so the market is giving the Fed some breathing room. But that could reverse quickly if the next CPI print comes in hot. Lucas: Absolutely. The May CPI report is due out June 10th. That's the next big catalyst. If core CPI surprises to the upside, you'll see the ten-year jump and maybe even pressure the Fed to consider a hike, not a cut. Luna: Which is wild, because consumer sentiment is screaming recession. But the Fed is looking at the bond market and the price data, not the mood ring. Lucas: If walking through the economy with us has made something click — maybe the way sentiment and rates diverge, or why the Fed is stuck — then this show stays ad-free because of listener support. It's buy me a coffee dot com slash fexingo. No pressure, just if you found today useful. Luna: Yeah, that's really what keeps us going. We don't sell ads, we don't have sponsors pushing a narrative. It's just us diving into the numbers. Lucas: And we love doing it. So let's get back to the data. One thing I find interesting is the divergence between the Russell 2000 and the S&P 500. The small-cap index is up 3.7 percent in the last five days, while the S&P is up only 1.1 percent. That's a big gap. Luna: Small caps are more sensitive to domestic economic conditions, and they're also more sensitive to interest rates. If the market is starting to believe the Fed will cut later this year, small caps would rally first. Lucas: Exactly. The Russell has been hammered by higher borrowing costs because small companies rely more on floating-rate debt. So a drop in the ten-year yield from 5.02 to 4.49 in a matter of weeks is a huge relief for them. Luna: But the Fed hasn't cut yet. So this is purely a expectations rally. The market is pricing in a cut maybe in September or December, but nothing is guaranteed. Lucas: Right. And that's the risk. If the May CPI comes in hot, those expectations get dashed, and small caps could give back those gains quickly. Luna: So we're in this waiting game. The data is mixed, the sentiment is terrible, but the hardest numbers — prices and employment — are still too firm for the Fed to act. Lucas: Let's look at one more data point: the ten-year breakeven inflation rate at 2.40 percent. That's up from around 2.30 a month ago, but still well below the 5.2 percent that consumers expect in the near term. The bond market is essentially saying, 'We trust the Fed will eventually get inflation under control.' The consumers are saying, 'We don't.' Luna: And the Fed is siding with the bond market. Which, in a way, is the right call. Consumers are reacting to the news cycle — war, high grocery prices, gas prices. The bond market is reacting to actual data on supply, demand, and central bank credibility. Lucas: But there's a limit. If consumer sentiment stays this low for another six months, it will eventually hit spending. People will start saving more, cutting back. And then the data will catch up to the sentiment. Luna: That's the soft landing scenario, right? The economy slows just enough to bring inflation down without a recession. But that's a narrow path, and we're not there yet. Lucas: Not yet. And the Fed is being careful not to declare victory prematurely. Kevin Warsh learned that lesson from the 2021-2022 inflation cycle, when the Fed called inflation 'transitory' and then had to hike aggressively. Luna: So we're stuck at 3.64 percent, watching CPI prints and yield moves. It's a weird kind of stability — but it's fragile. Lucas: Fragile is the right word. One bad inflation number, one escalation in the Iran conflict, and the whole picture changes. For now, the Fed is comfortable waiting. But the clock is ticking. Luna: And the consumer is getting more anxious by the day. That gap between sentiment and data can't persist forever. Lucas: No, it can't. And when it closes, that's when we'll get the next big move from the Fed — one way or the other.