Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Inflation Divergence the Fed Can't Ignore
Transcript
- Lucas: So we're looking at a peculiar moment in the inflation data. The June CPI came in at 332.6 — that's a decline from 333.98 in May. Headline inflation is cooling. But at the same time, the Fed's preferred gauge, the PCE price index, ticked up to 131.5 in May from 130.94. Core PCE, which strips out food and energy, rose from 129.67 to 130.1. So we have two inflation measures moving in opposite directions. Luna: And the Fed is supposed to target PCE, right? So even as CPI drops, their own metric is heating up. That's a real dilemma. Lucas: Exactly. And it's not just a measurement quirk. The gap tells us something about what's happening under the hood. CPI is a basket of goods with a heavier weight on housing and energy. PCE accounts for a broader range of services and adjusts for substitution — when people switch from beef to chicken because beef gets expensive, CPI doesn't catch that as quickly. So the divergence is telling us that the price increases are concentrated in areas that matter more to PCE: healthcare services, financial services, and insurance. Luna: And those are the sticky components. Things that don't go away quickly even if energy prices fall. Lucas: Right. Energy prices have been volatile, but the core services side is still climbing. Meanwhile, the labor market is incredibly tight. Unemployment dropped to 4.2 percent in June, and initial jobless claims just came in at 187,000 — that's extraordinarily low. So wages are still growing at a modest pace, but not enough to fuel demand-pull inflation. Luna: Yet the Fed has held the funds rate steady at 3.63 percent since June. No cuts, no hikes. How do they interpret these mixed signals? Lucas: That's the question. Chair Warsh — or rather, his language — has been parsed carefully. In his recent speeches, he's used phrases like 'vigilance on core services inflation' and 'data-dependent patience.' The market is reading that as a hold pattern. The 10-year breakeven inflation rate has actually declined to 2.21 percent from 2.26, so bond markets think inflation expectations are well anchored. But actual core PCE is moving up. Luna: So the markets are betting the Fed has it under control, but the data is telling a different story. Lucas: And that's where things get interesting. If core PCE continues to inch higher, the Fed might have to adjust its tone. They can't ignore their own target. But with CPI falling, they have cover to wait. So it's a waiting game. Luna: It's a lot to track, honestly. Lucas: It is. And that's why we do this show — to make sense of it. If walking through the economy with us has made something click, honestly, if today was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to keep this ad-free and independent. And we appreciate everyone who chips in. Lucas: Absolutely. Now, back to the data. The real question is: how long can this divergence last? Typically, CPI and PCE converge over time. But if the gap persists into August, the Fed will have to decide which signal to trust. Luna: And we've seen the Fed err on the side of caution before. They held rates too high for too long in 2023, and then had to cut aggressively when the data turned. Lucas: Right. But the difference now is that the labor market is actually stronger. The unemployment rate is below 4.3 percent, and jobless claims are near historic lows. That gives the Fed less urgency to cut. They can afford to be patient. Luna: So you're saying the bar for a rate hike is also higher? Even if PCE rises, they'd need to see a sustained trend? Lucas: Exactly. They want to avoid whiplash. One month of higher core PCE doesn't warrant a hike, especially when CPI is falling and breakevens are declining. But if we see three months of core PCE accelerating, then you bet they'll start talking about tightening again. Luna: So the next few months are crucial. The July CPI and PCE prints, due in August, will be the real test. Lucas: Yeah. The August releases will be the first real data point after the GDP rebound. We had real GDP growth annualized at 2.1 percent in the first quarter, up from just 0.5 percent. So the economy is picking up steam. If that growth is accompanied by rising core PCE, the Fed's job gets a lot harder. Luna: And then there's the global side — Singapore just tightened monetary policy, and import prices from China are rising. Those could add to cost pressures. Lucas: Right. The import price surprise last month was notable — costs of goods from China hit the highest since 2008. That filters into PCE eventually. So the Fed has to watch both domestic and international signals. Luna: So where does that leave the average investor? How do you position for a Fed that might be forced to hike again? Lucas: The bond market already sees a path. The yield curve is steep — the 10-year is at 4.64 percent, the 2-year at 4.40 percent. That's a positive spread, which usually signals future growth and maybe inflation. But it also means the market is pricing in higher rates for longer. So I'd say the safest bet is to expect patience from the Fed, but not complacency. Luna: Well, we'll be watching the data with you. Thanks for joining us on this episode of The Macro Memo. Lucas: Yeah, stay curious. We'll talk to you next time.