Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How Tariffs Are Rewiring Inflation Expectations
Transcript
- Lucas: Look at the headline numbers for August. Core CPI came in at three hundred thirty seven point eight, which is technically just a hair above the previous month. On paper, it looks like the Fed has won the battle against sticky services inflation. Luna: Right, but you know I’m always looking at what isn’t in the headline. The New York Fed released a note yesterday saying those specific price hikes were almost entirely tariff-driven. That changes the entire risk profile of the next meeting. Lucas: Exactly. And that is the trap we are walking into right now. When inflation comes from wage growth, the Fed can tighten to cool the labor market. But when it comes from imported goods due to policy decisions, raising rates actually hurts the consumer without fixing the supply side. It’s a policy mismatch. Luna: So we’re seeing a divergence between the data the Fed targets and the pain the consumer feels. Is the market starting to realize that higher rates might not stop these price increases? Lucas: It’s starting to. Look at the ten-year breakeven inflation rate. It dipped slightly to two point three three percent on Tuesday, but one-year inflation expectations in the latest Fed survey hit their highest level since May twenty twenty-three. People are worried about the future, even if today’s grocery bill hasn’t moved much. Luna: That fear premium is dangerous because it forces the Fed to act preemptively. If consumers expect prices to stay high, they change their behavior. They demand higher wages, which creates a feedback loop that has nothing to do with oil or housing. Lucas: And that feedback loop is why the effective federal funds rate is sitting at three point seven five percent while the daily overnight rate is flirting with three point eight eight percent. The spread tells us that banks are already pricing in a harder landing scenario than the official target suggests. Luna: It’s weird though, because the broader equity markets are still relatively calm. The S&P is up half a percent over the last week. Why aren’t investors selling off on the back of this tariff-inflation story? Lucas: Because they think the Fed will look the other way for a bit. There is an assumption that policymakers will treat tariff-induced inflation as a temporary supply shock rather than a persistent trend. But that assumption is cracking every time a new trade announcement hits the wire. Luna: So the real question is whether the Fed can afford to be patient. If they wait too long to signal that they don’t like this dynamic, do they lose credibility when the PCE data finally catches up? Lucas: That is the central dilemma. The PCE price index rose to one hundred thirty one point six in August. It’s slow, glacial growth, but it’s there. If the Fed stays idle while tariffs bite deeper into margins, they risk anchoring inflation expectations at two and a half percent instead of coming down to two. Luna: And that two and a half percent anchor is exactly what keeps mortgage rates elevated. So we have a situation where trade policy is effectively setting interest rates, bypassing the Federal Reserve entirely. Lucas: Precisely. It’s a form of de facto monetary tightening through fiscal policy. You are seeing the Treasury hiring advisors who challenge traditional Fed independence, like Judy Shelton, which signals a political willingness to let inflation run hot if it means reshoring manufacturing. Luna: That sounds like a direct challenge to the institutional framework. If the White House is explicitly trading lower growth for lower inflation dependence on foreign goods, the Fed is left holding the bag for the collateral damage. Lucas: The collateral damage is already showing up in the debt data. CNBC reported yesterday that Americans' debt problems are flashing warnings not seen since the Great Recession. High prices plus high borrowing costs means disposable income is being squeezed from both ends. Luna: So the Fed is watching a labor market that looks soft but a consumer balance sheet that looks brittle. How do they adjust the dial when turning it might trigger a recession, but leaving it alone guarantees entrenched inflation? Lucas: They probably don’t adjust it much at all. We are likely going to see a prolonged period of 'wait and see.' The FOMC minutes from the last meeting suggest they are waiting to see if the tariff effects are transitory. If they cut rates too early, they validate the inflation spike. Luna: But waiting carries its own risk. If the economy slows down because credit is too expensive, the Fed could find itself forced to cut aggressively into a stagflationary environment. That is a terrible place to be for bond yields. Lucas: Which is why the yield curve is flattening so aggressively. The ten-year Treasury yield dropped to five point two four percent. Investors are betting that growth will slow faster than inflation will fall. It’s a classic flight to quality play. Luna: I wonder if small caps are feeling this pressure more than large caps. The Russell is down one point four percent over the week. Those companies rely on domestic labor and local supply chains, which might be insulated from tariffs but are very exposed to the credit squeeze. Lucas: Spot on. Large caps can hedge currency risk and move production overseas. Small caps are stuck paying higher interest rates on floating debt while facing potential margin compression if they try to pass tariff costs onto customers who are already maxed out on credit cards. Luna: This feels like the exact same dynamic we saw in nineteen seventy-one, except the tools are different. Nixon shocked the world with price controls because he couldn’t fix the underlying imbalance. Are we heading toward some kind of administrative intervention? Lucas: Unlikely to be direct price controls, but we might see targeted subsidies or tax credits designed to offset the tariff burden for specific industries. That would be fiscal stimulus masquerading as industrial policy, which makes tracking true money supply even harder. Luna: So the data becomes noise. If the government injects cash to neutralize the tax, the inflation number goes up, but the economic reality doesn’t change. How do analysts even parse that anymore? Lucas: You have to look at the real variables. Volume, unit sales, and profit margins. If revenue is up but volume is down, you know prices are driving the top line. That is a recessionary signal wrapped in a bullish earnings report. Luna: It’s a tricky signal to send to the market. Investors love top-line growth, but they punish companies that lose market share while chasing it. We are going to see a lot of guidance revisions in the next quarter. Lucas: Absolutely. And that brings us to the donation segment, because listening to this unraveling of global trade dynamics really highlights why understanding these macro shifts matters for your personal portfolio. Luna: Yeah, it does. If walking through the economics of tariffs and inflation with us has made something click for you regarding how your money is affected... Lucas: then consider supporting the show directly. Listener contributions are what keep our research ad-free and allow us to dig into these complex policy intersections without corporate interference. Luna: You can find us at buy me a coffee dot com slash fexingo. It helps us keep bringing you these deep dives every single day. Lucas: Back to the data. Let’s talk about the VIX. Volatility is low, but it’s the quiet before the storm. When the next jobs report comes out, if unemployment ticks up even slightly, will the Fed interpret it as a sign to cut, or a sign that the tariff war is winning? Luna: I think they will panic-cut. They hate missing the inflation target more than they hate causing a recession. But cutting into a tariff-driven inflation spike is basically handing the victory to the bad actors in the system. Lucas: Or they stay flat, which preserves their credibility but risks breaking the consumer. It’s a lose-lose scenario for the institution. The only winner is whoever holds short-duration cash and waits for the yield curve to invert fully. Luna: That seems like the smartest play for now. Stay liquid, watch the breakeven rates, and don’t get fooled by the headline CPI number. The real story is in the trade flows. Lucas: Agreed. We will keep monitoring those flows. Thanks for listening.