Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How Energy Prices Are Reshaping the Feds Inflation Forecast
Transcript
- Lucas: The core PCE price index hit 3.4 percent in May, the highest reading since October 2023. That's the Fed's preferred inflation gauge, and it came out Thursday. Luna: Right, and the headline PCE was up too, but the core number is what the FOMC really watches. It's sticky. Lucas: Exactly. Now, 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. It's what keeps this show ad-free. Luna: Yeah, listener support really does make a difference. No pressure, just if you find value here. Lucas: So, back to that core PCE number. 3.4 percent. The Fed has been expecting inflation to ease gradually, but this print is a reminder that the last mile is the hardest. Luna: And it's not just demand-pull. The energy side is complicating things. Lucas: That's the angle I want to drill into. Because on the same day that core PCE came out, the 10-year breakeven inflation rate—basically the market's expectation for average inflation over the next decade—dipped to 2.20 percent. That's down from 2.21 the day before. It's a tiny move, but the direction matters. Luna: So the real-time market measure is going one way, but the lagging official data is going the other. That's a disconnect. Lucas: Right. And I think the missing variable here is energy. Specifically, the Strait of Hormuz. We've had this fragile U.S.-Iran deal, but then there was an attack on a vessel under the peace deal, and now Iran is warning ships that transit without their approval is 'unacceptable and dangerous.' The UN even paused its evacuation plan. Luna: That's a real supply risk. About 20 percent of global oil passes through the Strait of Hormuz. Lucas: Correct. And shipping costs have already rebounded in the past week, according to CNBC. So the Fed is now looking at an inflation picture where core services might be cooling gradually, but energy—and energy-sensitive goods—could push the headline numbers back up. Luna: The breakeven dipping might mean the market thinks the Fed will crush demand hard enough to offset the energy spike. But the FOMC might see it differently. Lucas: Exactly. The Fed's own forecast from the June dot plot showed median expectations for one or two quarter-point cuts this year. But with core PCE at 3.4 percent, and energy risk rising, that path looks much less certain. Luna: And remember, the Fed has been surprised before. They've repeatedly had to revise up their inflation forecasts. Episode 74 was about that. Lucas: Yeah, their forecasting record has been shaky. The issue now is that an energy shock is inherently harder to predict than domestic demand trends. You can model consumer spending pretty well. You can't model geopolitics. Luna: So what do they do? Hold rates steady and wait? Or signal that they're prepared to hike again if energy feeds through? Lucas: I think the most likely path is a prolonged hold. The Fed funds rate is at 3.63 percent effective as of May. That's already restrictive. But they won't cut until they see convincing evidence that core PCE is trending back toward 2 percent. And energy could delay that evidence by months. Luna: There's also a stagflationary risk here. If energy prices spike and the economy slows, the Fed has a really tough choice. Lucas: Stagflation is the word on everyone's lips, but I think we have to be careful with it. The labor market is still relatively strong. The unemployment rate is low. We're not in a 1970s-style wage-price spiral. But the combination of above-target inflation and fragile growth is exactly the kind of environment where the Fed could be forced into an error. Luna: And the error could go either way—tightening too much and causing a recession, or easing too soon and letting inflation become entrenched. Lucas: Precisely. So let's look at what the actual numbers are telling us. The CPI for May was 334.0, up from 332.41 in April. Core CPI was 336.1, up from 335.42. So the monthly pace of increase is still around 0.3 percent or so. That annualizes to over 3.5 percent. Not consistent with the 2 percent target. Luna: And the PCE data, which includes substitutions and different weights, is a bit lower but still above target. The core PCE price index level was 130.1 in May, up from 129.67. Lucas: Right. So the trend is not decisively down. And now we add the energy uncertainty. The question is how much of that energy cost gets passed through to core goods and services. If shipping and fuel costs rise, you'll see it in transportation services, in retail goods, in airline fares. Luna: And the Fed can't really do anything about that. They can't drill for oil or negotiate with Iran. Lucas: No, but they can tighten financial conditions to reduce demand. That's the blunt instrument. The risk is that they overtighten and break something in the labor market or the banking system. Luna: We talked about commercial real estate in Episode 59. That's still a vulnerability. Higher rates for longer put more pressure on those loans. Lucas: Absolutely. So the Fed is walking a very narrow path. They have to communicate that they are vigilant on inflation, but not so hawkish that they spook markets and tighten conditions more than intended. Luna: And the market is already pricing in that tension. The 10-year Treasury yield is at 4.37 percent today. The 2-year is at 4.13 percent. That's still a mildly inverted curve, but much less than it was. Lucas: The curve uninversion we talked about in earlier episodes was seen as a signal that recession risk was receding. But if energy shocks push inflation up, the curve could invert again. It's a very fluid situation. Luna: So looking ahead to the July FOMC meeting, what's your base case? Lucas: No move. They'll hold rates steady and use the statement to acknowledge that inflation progress has stalled and that they are watching energy developments closely. They'll want to keep all options open. Luna: And the press conference? Powell will likely be asked about the Hormuz situation. Lucas: I'd expect him to say that the Fed is monitoring supply-side developments but that monetary policy is not well-suited to address temporary energy shocks. He'll emphasize the need to look through transitory effects—though that word burned them before. Luna: Right, 'transitory' came back to haunt them in 2021. They'll be careful not to repeat that mistake. Lucas: Exactly. So the key takeaway from this episode is that the energy channel is the new wildcard in the inflation outlook, and it could delay rate cuts well into 2027. The core PCE at 3.4 percent is a flashing yellow light, and the Hormuz situation could turn it red. Luna: And the breakeven rate dipping shows the market is betting the Fed will win, but that bet is fragile. Lucas: Fragile is the right word. One more attack in the Gulf, and all bets are off.