Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Stuck Between PCE and the Strait of Hormuz
Transcript
- Lucas: So the core PCE number for May landed at 3.4 percent — the highest since October 2023. And the FOMC just met two weeks ago, left rates unchanged, and essentially said they need more data before they can cut. Luna: Right — and the market's immediate reaction was a bit of a sell-off in equities, especially the Nasdaq, which is down over three percent in the last five days. Lucas: Exactly. The Nasdaq at 25,298 is feeling the rate-sensitive pinch. But here's the thing I keep coming back to: the Fed's preferred inflation gauge is now telling them something they've been hoping wouldn't happen — inflation reaccelerating. And the complicating factor isn't domestic demand; it's the Strait of Hormuz. Luna: You're talking about the headlines from this week — the U.S.-Iran deal seemed to calm things, but then a vessel was attacked, and the UN paused its evacuation plan. Shipping is trying to rebound, but confidence is fragile. Lucas: Fragile is the word. Iran is explicitly warning ships not to transit without their approval. That's an effective threat to a chokepoint that handles about a fifth of global oil supply. If that channel gets disrupted meaningfully, energy prices spike, and that flows into headline inflation almost immediately. Luna: Which then bleeds into core — because transportation costs, petrochemicals, all of that feeds into goods prices. The Fed can't just look past energy the way it used to. Lucas: And that's the uncomfortable spot. The ten-year breakeven inflation rate, which is basically the market's expectation for average inflation over the next decade, actually dipped to 2.20 percent this week. That's down from 2.21 previously. So the bond market is saying, 'We still think the Fed gets inflation under control long-term.' But the near-term path just got murkier. Luna: So you've got a divergence — short-run inflation data getting worse, long-run expectations still anchored. That's a classic fed credibility scenario, isn't it? Lucas: It is. And it's why the FOMC's dot plot from the June meeting is already stale. They projected two cuts this year, but that was before the May PCE number and before the Hormuz situation deteriorated again. The data-dependent framework works fine when data evolves slowly. When geopolitics throws a grenade, it's a lot harder. Luna: I mean, the Fed Funds rate is sitting at 3.63 percent effectively, and the interest on reserve balances is 3.65. They're basically saying the current level is restrictive enough. But if inflation ticks up again, they can't cut. They might even have to talk about hiking. Lucas: And no one on the FOMC wants to do that. Hiking would be politically brutal and economically risky — especially with the yield curve still not fully uninverted. The two-year is still above the ten-year by a bit. An inverted curve that re-widens could signal recession fears returning. Luna: Let's talk about the core PCE components for a second. The report showed services inflation staying sticky. That's been the Fed's nightmare — the part of inflation that's hardest to squeeze out. Lucas: Services inflation is driven by labor costs, housing, healthcare — things that don't respond quickly to interest rates. So even if the Fed holds rates high, those categories take months or years to cool. And right now, the labor market is still adding jobs, wages are still growing around four percent. That keeps pressure on. Luna: But the Fed's own forecasts have been wrong consistently. They predicted inflation would fall faster than it has. Chair Powell acknowledged that in the press conference — said they're humble about the outlook. Lucas: Humility is appropriate when your models keep missing. And now they have to factor in a potential supply shock from the Middle East. That's something monetary policy is particularly bad at addressing. You can't cut rates to offset an oil price spike — that would just add demand-side fuel to the fire. Luna: So what's the play? Do they just wait and hope the geopolitical situation stabilizes? Lucas: I think that's exactly what they'll do. Wait. Hold rates steady, watch the data, and hope that the Strait of Hormuz doesn't become a prolonged disruption. The risk is that 'wait and see' becomes 'wait and watch inflation settle at 3-plus percent.' Luna: And if that happens, the breakeven inflation rate might start moving up. That would be the signal that long-term expectations are becoming unanchored. Lucas: Which is the one thing the Fed absolutely cannot allow. They'll do whatever it takes to keep long-term expectations anchored, even if that means keeping rates higher for longer. But the cost of that is slower growth and potentially a harder landing for the economy. Luna: It's a tough needle to thread. And honestly, episodes like this — where we walk through the cross-currents — if it made something click for you, that's the kind of thing listener support makes possible. Lucas: Yeah, we keep this show independent and ad-free, and it's just listeners like you who make that work. If today's conversation was worth a coffee to you, you can find us at buy me a coffee dot com slash fexingo. Luna: No pressure, just a note that it helps. And it keeps us digging into these connections. Lucas: Alright — back to the Fed's dilemma. One more piece of data that's interesting: the ten-year Treasury yield is at 4.37 percent, down about three percent over the last five days. That's a notable move. Bond markets are pricing in a softer economic outlook, maybe even a cut later this year. But if core PCE stays elevated, that trade could reverse quickly. Luna: So the bond market is betting the Fed will cut despite inflation? That seems like a contradiction. Lucas: It is, unless you believe that the economy is slowing enough to bring inflation down on its own. The GDP data for the second quarter isn't out yet, but some high-frequency indicators are softening. Consumer spending, housing — they're showing cracks. So the market might be saying, 'The Fed will cut because growth is fading, not because inflation is tamed.' Luna: That's a very different narrative than the one the FOMC is putting out. They're still focused on inflation. They don't want to cut prematurely and repeat the 1970s mistake. Lucas: Right. And that's the tension. The market is ahead of the Fed on rate cuts, but the Fed is ahead of the market on inflation persistence. One of them is going to be wrong. The question is which one. Luna: And then throw in an exogenous shock from Hormuz, and the error bars get huge. Lucas: Exactly. That's why I think the next few months are going to be particularly interesting for Fed watchers. The data is going to be noisy, the geopolitics are unpredictable, and the FOMC is going to have to communicate very carefully to avoid spooking markets. Luna: Maybe that's the real story — not just the inflation number, but how the Fed manages expectations in a fog of war. Lucas: I think that's right. Communication becomes as important as the rate decision itself. And so far, they've been consistent: data-dependent, patient, humble. But consistency might not be enough if the data keeps surprising. Luna: We'll be watching the July meeting closely. No rate change expected, but the statement language could shift. Lucas: Absolutely. And the minutes from the June meeting come out in a couple weeks — that'll give us more color on how seriously they're taking the supply-side risks. For now, it's a waiting game. Luna: Thanks for joining us on this episode of The Federal Reserve Podcast.