Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Fed's 3.62 Percent Rate Trap and What It Means for You
Transcript
- Lucas: So the Fed just cut rates again, bringing the federal funds rate down to 3.62 percent. That's the fourth cut in this cycle. But here's the weird part — core PCE inflation, the Fed's own preferred gauge, is still running at 3.3 percent annualized. That's half a percentage point above their 2 percent target. So why are they cutting? Luna: Yeah, that does seem backward. Usually you cut when inflation is tamed, not when it's still sticky. Lucas: Right. And look, the market had been pricing in these cuts because the economy is slowing. Real GDP growth in the first quarter was only 1.6 percent annualized. That's down from 2.5 percent in the fourth quarter of last year. So the Fed is trying to get ahead of a potential downturn. Luna: But if they cut too fast, doesn't that risk re-igniting inflation? Especially with energy prices spiking because of the Iran situation. Lucas: Exactly. And that's the tension. The headline CPI hit 332.4 in April, up from 330.29 in March. A lot of that is energy. We've talked before about the Iran war adding about $450 per household in higher gas and utility costs. But the core number — which strips out food and energy — is also sticky. Core CPI is at 335.4, up from 334.17. Luna: So they're cutting into a headwind from geopolitics. That seems risky. Lucas: It does. But let's look at why the Fed might feel comfortable. One big factor is housing inflation, which is finally starting to ease. Rent and owners' equivalent rent have been lagging indicators — they follow market rents by about 12 to 18 months. And the new lease data from 2024 and early 2025 is now flowing through. Luna: So the Fed thinks this 3.3 percent core PCE is a lagging picture, and that the real-time inflation is actually lower? Lucas: That's the thesis. Minneapolis Fed President Kashkari said this week that the inflation fight takes priority, but he also acknowledged the labor market is 'in decent shape.' Unemployment is at 4.3 percent, which is historically low. Nonfarm payrolls added 115,000 jobs in April. So the economy isn't collapsing. Luna: But 115,000 is below the trend. We were averaging 200,000-plus for most of last year. Lucas: Yes, and initial jobless claims ticked up to 215,000 from 210,000. So there are cracks. The Fed seems to be saying: we've done enough on inflation for now, let's support the labor side. But here's the catch — if energy inflation persists, that could feed back into core inflation. Luna: And then they'd have to reverse course. That's the nightmare scenario — cut rates, inflation re-accelerates, then hike again. Lucas: Right. A 'stop-go' cycle. We saw that in the 1970s. But so far, the bond market is giving the Fed some benefit of the doubt. The 10-year breakeven inflation rate is at 2.40 percent. That's up a bit from 2.38, but it's still anchored below 2.5. The bond market isn't panicking about inflation. Luna: But the yield curve is still inverted. The 10-year is at 4.47 percent, the 2-year is at 3.62? Wait, no — the 2-year is 3.62? That's the fed funds rate. Lucas: Close. The 2-year Treasury yield is 3.62 percent, same as the fed funds rate. The 10-year is 4.47, so the curve is actually steepening. It's no longer deeply inverted like it was last year. That's a classic sign that the market expects rate cuts ahead. Luna: So the bond market is saying: the Fed will cut more. But inflation is still above target. Something has to give. Lucas: Yeah, and that's the debate. Some economists argue the neutral rate — the rate that neither stimulates nor restricts the economy — has risen. If that's true, then 3.62 percent isn't really that stimulative. It might be close to neutral. Luna: That's a whole different conversation. If neutral is higher, then these cuts aren't really 'easing.' They're just recalibrating. Lucas: Exactly. And that's what some Fed officials are hinting at. But it's hard to know in real time. For the average person, what matters is what this means for their savings account and mortgage. Savings rates are already dropping — the 1-year Treasury is at 3.62 percent. So if you locked in a CD at 5 percent last year, that's gone. Luna: And mortgage rates? The 10-year yield at 4.47 suggests 30-year fixed rates around 6.5 to 7 percent. Still high. Lucas: Right. So the housing market remains frozen for many. But if the Fed keeps cutting, mortgage rates could drift lower. The question is whether they can cut without triggering another inflation wave. And that brings us back to the Iran situation. Every dollar higher at the pump is a dollar less in consumer spending — but it also pushes up inflation. Luna: Which is exactly the kind of thing that makes the Fed's job harder. By the way, if walking through the economy with us has made something click — or if you just enjoy having a daily economics conversation without ads — we keep this show going because of listeners like you. Lucas: Yeah, that's right. We don't run sponsor spots or sell your data. It's just us and the data. So if you find value in these ten-minute breakdowns, you can support the show at buy me a coffee dot com slash fexingo. No pressure, no perks — just a way to keep the mic on. Luna: And it really does help. We put everything into researching these episodes. So thank you. Lucas: Alright. Back to the Fed. One more data point I think is worth watching: the interest on reserve balances is at 3.65 percent. That's the rate the Fed pays banks to park reserves. It's actually slightly above the fed funds rate. That tells you the Fed is still trying to keep a floor under short-term rates. Luna: Which is another subtle signal that they're not in full-on easing mode. They're being cautious. Lucas: Exactly. So the picture is: the Fed is cutting, but reluctantly, and with one eye on inflation. The market expects maybe two more quarter-point cuts this year. But if core PCE doesn't budge below 3 percent, that forecast could change quickly. Luna: So what should a listener do with this information? If they have cash, lock in a rate now before it drops further? Lucas: That's one view. If you can get a 1-year CD at 3.6 percent, that's fine. But bonds might be better if you think rates will fall further. The 10-year at 4.47 offers a decent yield and price appreciation if yields drop. Just be aware of duration risk. Luna: And for borrowers? Anyone with a variable-rate loan should consider refinancing to fixed if they can. Lucas: Absolutely. The window is open, but it might not last. Because if inflation doesn't cooperate, the Fed could pause — or even reverse. A lot depends on the next two CPI reports and what happens in the Middle East. Luna: So the bottom line: the Fed is cutting, but it's not a all-clear signal. It's a cautious recalibration in a world where the neutral rate might be higher than we thought. Lucas: That's a great way to put it. The old playbook doesn't fit perfectly. We're in a regime where inflation is stickier, geopolitics are messier, and the labor market is resilient but slowing. The Fed is navigating by feel, not by rule. And that's what makes this so interesting — and so uncertain. Luna: Well, we'll keep watching the data. Next episode we'll dig into the jobs report due out this Friday. Lucas: Looking forward to it. Until then, keep your eyes on those breakevens.