Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Energy Blind Spot Behind Core CPI Right Now
Transcript
- Lucas: So the May CPI print came in at 4.2 percent year-over-year, which is the highest we've seen in three years. The immediate reaction in markets was actually pretty muted — the S&P barely moved, the ten-year yield dipped a couple of basis points. Which tells you that investors are reading this as an energy story, not a broad demand story. Luna: Right, because core CPI — ex food and energy — was only 3.6 percent. That gap between 4.2 and 3.6 is almost entirely gasoline and heating fuel. Lucas: Exactly. And that's the exact kind of split the Fed loves to point to when they say 'this is transitory.' But here is the problem: the wholesale price data from yesterday showed producer prices rose 1.1 percent in May, way above expectations, and that was also led by energy. So the pipeline is still hot. Luna: And the ECB just hiked rates for the first time since 2023, specifically citing the Iran war energy spike. The European Central Bank is basically saying this energy shock is persistent enough to warrant tightening. Lucas: Which puts the Fed in an awkward spot. They've been on hold since last September, with the effective fed funds rate at 3.63 percent. The narrative has been 'we can wait, inflation is coming down slowly, the labor market is still solid.' But now you have headline CPI accelerating, your major central bank peer is hiking, and the geopolitical source of the energy spike — Iran conflict — shows no sign of de-escalating. Luna: So is the Fed's 'transitory' argument in trouble? Because they used that word in 2021 and it aged terribly. Lucas: Look, they're not using the word transitory this time. But they are implicitly relying on the same logic: that energy price shocks work their way through the data in about 12 to 18 months, and if you look through them, the underlying inflation trend is still toward 2 percent. The ten-year breakeven inflation rate — that's the market's expectation for average inflation over the next decade — actually fell to 2.29 percent, down from 2.34 a week ago. So bond traders are betting this spike fades. Luna: But that breakeven is still above the Fed's 2 percent target. And it's been stubbornly above 2.2 for months now. Lucas: Right. And the core PCE price index, which is the Fed's preferred measure, is at 129.6 — up from 129.32 the month before. That's a 0.2 percent month-over-month increase, which annualizes to around 2.4 percent. So we are not at target yet, even stripping out food and energy. Luna: So the energy surcharge is masking a core that's still running a bit hot. Lucas: Exactly. And the question for the FOMC meeting next week is whether they acknowledge that tension more explicitly. My guess is they stick with 'data dependent' and keep rates where they are. But the risk is that if energy stays elevated into the fall, headline CPI could push toward 5 percent, and then the political pressure to act becomes intense. Luna: Especially in an election year. And we already saw the May jobs report showed solid payroll growth — 272,000 — so the economy isn't begging for rate cuts either. Lucas: So the Fed is basically in a holding pattern, watching two numbers: the breakeven inflation rate, and the month-over-month change in core PCE. If core PCE starts accelerating again, or if breakevens push above 2.5, they'll have to consider a hike. But for now, they're betting the energy spike is a one-off. Luna: Which is exactly what they bet in 2021. And we know how that turned out. Lucas: To be fair, the circumstances are different. In 2021, the energy spike was part of a broader demand surge driven by fiscal stimulus and supply chain bottlenecks. This time, the spike is purely geopolitical — Iran conflict, sanctions, shipping disruptions. The Fed can't do much about that. But what they can do is prevent it from feeding into expectations. Luna: And that's why the breakeven is so important. If consumers and businesses start expecting 3 or 4 percent inflation, then wage demands adjust, pricing power adjusts, and it becomes a self-fulfilling prophecy. Lucas: Exactly. And you see early signs of that in the New York Fed's survey of consumer expectations — households are starting to expect higher inflation a year from now. That's the kind of number that keeps Fed officials up at night. Luna: If today's episode helped you make sense of that CPI number or the Fed's next move, you know we keep this show ad-free and independent. The way that stays true is listener support — buy me a coffee dot com slash fexingo. Seriously, it makes a difference. Lucas: Absolutely. A quick coffee's worth of support keeps the lights on and the analysis grounded. We really appreciate it. Luna: So back to the data — one more thing I found interesting: the yield curve is still deeply inverted, with the two-year at 4.19 percent and the ten-year at 4.46 percent. That's actually less inverted than it was a month ago, but it's still signaling recession risk. Lucas: Right, the two-year is below the ten-year now — that's a normalizing curve, which historically has been a late-cycle signal. But the Fed is essentially saying 'we'll take that risk because the alternative is letting inflation become entrenched.' And the market is pricing in about a 30 percent chance of a rate cut by December — so traders think the economy will weaken enough that the Fed reverses course. Luna: That's a huge divergence. The Fed is on hold, the market wants cuts, and the ECB is hiking. Something has to give. Lucas: It usually does. And the catalyst could be the next CPI print in July, or the next jobs report, or some geopolitical event. But for now, the Fed is comfortable being patient. The question is whether the data lets them stay comfortable. Luna: And whether 'patient' becomes 'behind the curve' if energy doesn't cool off. Lucas: That's the million-dollar question. And we'll be watching the breakeven and core PCE like hawks.