Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / Why Stagflation Is Breaking the Rules of Core Inflation
Transcript
- Lucas: So Luna, I keep coming back to a number that feels almost backwards. The Fed's preferred inflation gauge, the core PCE price index, rose 3.3 percent annually in July. That's hot. But headline inflation is running cooler, around 2.6 percent if you use the same measure. And real GDP growth is down to 1.5 percent annualized. That's the textbook definition of stagflation, yet the details are weirdly different from the 1970s. Luna: Weirdly different how? I mean, 3.3 percent core with slow growth sounds pretty 1970s to me. Lucas: Right, but the composition is off. In the 1970s, the headline number was usually the scary one, driven by oil and food shocks. Today, it's the opposite. Core is running hotter than headline, which means it's not about commodities. It's about services, rents, insurance, things that are stickier and harder to shake. Luna: So the inflation we have is more embedded. That actually sounds worse in some ways. Lucas: It is, because it means the Fed can't just wait for oil prices to normalize. They've got a slow-burn inflation that's coming from domestic demand and supply constraints. And you add that to a labor market that's still tight—unemployment at 4.1 percent, job openings still above seven million—and you get a policy headache. Luna: And the Fed's new chair seems to be leaning hawkish. Warsh said he's concerned about inflation and wants a 'quieter' central bank. That's a shift from the last few years of forward guidance. Lucas: Exactly. And Hammack came out and said 'now is the time to act' on rates. That's pretty direct language. But here's the puzzle: if the Fed raises rates into a slowdown, they risk tipping the economy into recession. If they don't, inflation stays sticky. There's no clean exit. Luna: So the bond market is trying to figure out which mistake they'll make. The ten-year breakeven inflation rate actually ticked down to 2.31 percent this week. That suggests investors think the Fed will eventually get inflation under control, even if it means pain. Lucas: And that's the 1970s echo I keep circling. The breakevens are behaving like the Volcker era, not the Burns era. But the yield curve is doing something strange. It's not inverted the way it was in 2023. It's actually steepening, which is odd for a slowdown. Normally, you'd see short rates fall more than long rates. Luna: What does a steepening curve tell you in this environment? Lucas: It might be saying the market doesn't fully believe the Fed will hike. They see growth slowing, so they think the Fed will blink. But if the Fed actually follows through on Hammack's talk, short rates go up, the curve flattens, and we're back to the classic pre-recession signal. Luna: So it's a credibility test. The market is trying to call the Fed's bluff. Lucas: Precisely. And with Warsh wanting to communicate less, the Fed might end up surprising markets more. That's the opposite of what you want in a period of high uncertainty. Luna: I saw Druckenmiller is leading a group of doubters on Bessent's bond strategy. That's another layer of uncertainty. What's your take on that? Lucas: I think Druckenmiller's skepticism is rooted in the idea that you can't solve a supply-side inflation with fiscal engineering. Bessent is trying to manage the yield curve and debt issuance, but if the Fed is hiking, the Treasury's job gets harder. The two arms of policy are pulling in different directions. Luna: So you've got fiscal stimulus at a time when the Fed wants to tighten. That's a recipe for tension. Lucas: Exactly. And it brings me back to the core inflation story. One reason core is sticky is that rents and services are still adjusting to the earlier surge in housing costs. Those take years to work through. So even if goods prices fall, the service side keeps the core elevated. Luna: That's the kind of insight that makes you want to support independent economics journalism. If you're finding these conversations helpful, consider buying us a coffee at buy me a coffee dot com slash fexingo. It keeps the show ad-free and helps us dig into these numbers properly. Lucas: Yeah, we really appreciate that. But let's get back to the data, because there's another wrinkle. The unemployment rate actually fell to 4.1 percent from 4.2 percent, even as payrolls declined slightly. That's a bit contradictory. You'd expect unemployment to rise if payrolls are shrinking. Luna: Unless the labor force participation rate dropped. People left the workforce, so the unemployment rate looks better than it really is. Lucas: Bingo. And that's a classic stagflation sign. You have people dropping out because they can't find good jobs or because wages aren't keeping up with inflation. The headline unemployment rate masks the underlying weakness. Luna: And wage growth is basically flat. Average hourly earnings are up only 3.6 percent year-over-year, which is below the core inflation rate. So real wages are actually falling. Lucas: That's the squeeze. Consumers are feeling it, and you can see it in the savings rate falling. We did an episode on that a few weeks back, but it's worth repeating: when real wages fall, people either save less or borrow more. Neither is sustainable. Luna: So you have a consumer that's stretched, a Fed that's hawkish, and a bond market that's skeptical. What breaks first? Lucas: That's the million-dollar question. Corporate earnings calls are starting to sound more cautious. We covered that in episode 168. But I think the real test will come in the next few months when the full impact of rate hikes hits the housing market and commercial real estate. Luna: And if inflation stays sticky, the Fed might have to keep hiking into that weakness. That's the nightmare scenario. Lucas: It is. But here's the thing: the 1970s taught us that you can't stop hiking halfway. Volcker had to cause a recession to break inflation. Warsh seems to understand that. The question is whether the economy can take it this time, given the debt load. Luna: We talked about the debt mountain in episode 160. With rates higher, the interest on the debt eats up more of the budget. That limits fiscal space to cushion a downturn. Lucas: Exactly. And that's why the core inflation story is so important. It's not just a number. It determines whether the Fed can afford to be patient. If core stays at 3.3 percent, they can't. They have to act, even if it means a recession. Luna: But wouldn't a recession bring inflation down quickly? That's the silver lining, right? Lucas: It would, but at a cost. The 1980-82 recession was brutal. Unemployment hit double digits. And even then, inflation didn't fall overnight. It took years to get back to 4 percent. Today, with services inflation so embedded, it might take even longer. Luna: So the core versus headline gap is really the canary in the coal mine. Lucas: I think so. If core starts to moderate, you can argue that the worst is behind us. But until then, the Fed has to assume that inflation is a persistent problem. And that means higher for longer is the base case. Luna: And the bond market is pricing that in? The breakevens are down, but that could be about oil prices falling, not about inflation expectations improving. Lucas: Right. Breakevens are a mix of inflation expectations and risk premia. It's hard to disentangle. But the fact that the ten-year breakeven is 2.31 percent, well below core inflation, tells me the market thinks the Fed will eventually win. It's just a question of how much pain it takes. Luna: And with Warsh wanting to communicate less, there's more room for surprises. That could make the pain worse if the market isn't prepared. Lucas: Absolutely. Central bank communication is a tool. If you take it away, you lose the ability to manage expectations. And in a stagflationary environment, expectations are everything. If people expect inflation, they act accordingly, and it becomes self-fulfilling. Luna: So the 'quieter' approach might be a mistake. That's a bold take. Lucas: It's a risk, at least. The Fed under Powell was very transparent, and that helped. But Warsh has a point that too much guidance can become a constraint. It's a delicate balance. And in a time when the economic data is sending mixed signals, clarity from the Fed becomes even more valuable. Luna: So where does that leave the average person? What should they be watching? Lucas: I'd say watch the core inflation numbers, not the headline. They're a better guide to the underlying trend. And watch the Fed's actions, not their words. If they hike in September despite the slowdown, that tells you they're serious. Luna: And if they don't hike, then the market takes over. Lucas: Exactly. The market will do the tightening for them. And that could be messier. But that's the reality of a 1970s-style economy. There are no clean options, only difficult trade-offs. The good news is we've been through this before. The bad news is we might have to relearn the lessons the hard way. Luna: Let's hope not, but you've given us a lot to think about. Thanks, Lucas. Lucas: Anytime, Luna. And to our listeners, keep questioning the numbers you see. The core story is where the real signals are.