Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the K-Shaped Recovery
Transcript
- Lucas: So there's this phrase that keeps popping up in economics right now — the K-shaped recovery. And it's one of those ideas that sounds like a metaphor but is actually doing a lot of work in how the Fed is thinking about the next few months. Luna: K-shaped, as in the letter K — some lines go up, some lines go down? Lucas: Exactly. The top arm of the K is the upper-income consumer — their portfolios are up, they're still spending on travel and services, they're basically insulated from the inflation that's hitting everyone else. The bottom arm is everyone else — wage earners who are seeing rent and groceries eat up their paychecks, and small businesses that are still struggling with higher input costs. Luna: And the Fed is supposed to set one interest rate that works for both arms? Lucas: That's the tension. And it's not academic. The latest core PCE reading — the Fed's preferred inflation gauge — came in at 3.3 percent annualized for July. That's down from last year but still well above the 2 percent target. So you have sticky inflation on one side, and you have a consumer that's increasingly bifurcated on the other. Luna: So what does the Fed actually do with that? Raise rates to cool off the top arm, even if it hurts the bottom arm? Lucas: Right. And that's the debate happening right now inside the Federal Reserve. You've got Cleveland Fed president Beth Hammack saying 'now is the time to act' on rate hikes — that was earlier this week. But you also have others, like Chair Warsh, who's saying he's concerned about inflation but he wants a 'quieter' central bank, less forward guidance, more flexibility. Luna: Warsh — that's the new chair, right? Appointed earlier this year. Lucas: Yeah, Kevin Warsh took over in March. And he's already signaling a different style than Powell. Less pre-commitment, more data dependence. But the data is kind of sending mixed signals, which brings us back to the K. Luna: Before we go further — and I know this is a bit of a pivot — but we've been talking about how the economy feels different depending on who you are. And that's kind of how it is with this podcast too. A lot of people listen for free, and that's great. But for those who've gotten something out of these episodes and want to keep it going, a couple of dollars a month genuinely makes a difference. It's buy me a coffee dot com slash fexingo. Lucas: Yeah, exactly. We keep the show ad-free, and that's only possible because of listener support. No pressure, but if you've learned something here, that's the way to keep it rolling. Luna: And we're back to the K. So what's the actual evidence that the recovery is splitting like that? Lucas: Well, look at the yield curve. The ten-year Treasury is at 4.72 percent right now, and the two-year is at 3.73. That's an inverted curve, which historically signals a recession. But the inversion is mild, and it's been inverted for over a year now without a recession. Why? Because the top arm of the K is keeping the economy afloat. Luna: So the bond market is saying 'slowdown' but the stock market is near record highs. The S&P is above 7,700. Lucas: Right. And that divergence is the K in market form. Corporate profits are strong, especially for big tech and luxury goods. But consumer confidence among lower-income households is still depressed. It's not a uniform recovery. Luna: And how does that play into the Fed's decision? If the bottom arm is struggling, maybe they should cut rates. But inflation is still above target. Lucas: That's the crux. And it's why you have officials like Hammack arguing for a hike — she sees the sticky core inflation and thinks the Fed needs to do more. But others worry that a hike would be a sledgehammer on the bottom arm, especially with the labor market already cooling. The unemployment rate ticked up to 4.3 percent in July, and job gains are slowing. Luna: So it's a coin toss. What do you think they'll do in September? Lucas: I think they'll hold. But the statement will emphasize that they're not on a preset path. Warsh is going to want to keep every option on the table, and that's actually a shift from the Powell era, where they gave more explicit forward guidance. The Fed is going back to being a 'quieter' central bank, and that means the market has to live with more uncertainty. Luna: And that uncertainty itself — is that a problem? Lucas: It can be. If the market doesn't know what the Fed will do, that can feed into volatility. But Warsh's view is that the Fed shouldn't be the source of certainty — it should react to data. And the data is genuinely mixed. Look at the Treasury General Account — it's been running down as the Treasury spends down its cash buffer. That's a liquidity injection into the market, which is supportive for risk assets. But it's also a signal that the fiscal situation is getting tighter, which is why you see these debates about the debt ceiling again. Luna: So the Fed is kind of caught between inflation and a fiscal wall. Lucas: Exactly. And that's why the K-shaped framework is useful. It reminds you that the economy isn't one thing. The Fed has to thread a needle between an upper-income consumer that's still spending and a lower-income consumer that's running out of savings. One rate doesn't fit both. Luna: And what about the inflation expectations? The ten-year breakeven is at 2.31, which is close to target. So the market seems to trust the Fed long-term. Lucas: That's the good news. Long-term expectations are anchored. That gives the Fed room to wait. But the core PCE at 3.3 percent is still too high for comfort. And if inflation stays sticky, they might have to act even if it hurts the bottom arm. That's the tough call. Luna: So the K might actually determine the next move. Lucas: I think it's already determining the internal debate. And it's going to be the lens through which they read the upcoming jobs report and the next CPI print. If the top arm stays strong, they might feel okay holding. If the bottom arm weakens further, they might feel pressure to cut — but only if inflation cooperates. Luna: It's a tough spot. And it's not just a US thing, right? Other central banks are dealing with similar splits. Lucas: Totally. In Europe, the ECB is watching the same kind of divergence between services inflation and goods inflation. And in emerging markets, the K is even starker. But that's a whole other episode. Luna: Fair. So for now, we watch the data. And the FOMC statement. Lucas: Yeah. And the thing to watch is not just the rate decision, but the language. If they drop the 'patient' phrase or add something about 'vigilance,' that will tell you more than the number itself. Warsh is going to be very deliberate with his words, because he knows the market is listening. Luna: And so are we. Thanks for breaking this down, Lucas. Lucas: Anytime. And if this conversation made something click, you know how to support us. Buy me a coffee dot com slash fexingo. We'll be back tomorrow.