Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Fed Is Stuck at 3.6 Percent with Inflation at 4.2
Transcript
- Lucas: So the Fed is sitting at a fed funds rate of 3.6 percent. Inflation is running at 4.2 percent. That means the real fed funds rate — the rate after subtracting inflation — is deeply negative, around negative 0.6 percent. Luna: Which sounds like the opposite of tight policy. If rates aren't even keeping pace with inflation, how is that supposed to cool the economy? Lucas: Exactly the question. The Fed hiked from near zero to 3.6 percent over the past couple years. But inflation didn't sit still — it accelerated again. The May CPI came in at 4.2 percent annualized, the highest in three years. Luna: And the Fed's key tool, the real rate, is still negative. So they're not actually restraining the economy in real terms. Lucas: Right. Historically, the Fed has needed a positive real rate of maybe 1 to 2 percent to really cool inflation. We're not even close. That's the trap: to get rates truly restrictive, they'd have to hike more — but growth is already wobbling. Luna: Real GDP growth annualized was just 1.6 percent in Q1. Not a recession, but not robust either. Hike too much and you might tip things over. Lucas: And the labor market is sending mixed signals. Unemployment held at 4.3 percent in May, which is low by historical standards. But JOLTS job openings surged to 7.6 million in April — that's up from 6.9 million the month before. A big jump. Luna: That's the opposite of what you'd expect if the economy was cooling. Employers are still desperate for workers, which puts upward pressure on wages and, ultimately, prices. Lucas: Average hourly earnings are up to $37.50. That's about 4.3 percent year-over-year. So wage growth is running above inflation, which is great for workers but makes the Fed's job harder. Luna: And then there's the global picture. The ECB just hiked rates for the first time since 2023, specifically because the Iran conflict is driving up energy costs. That adds another layer of complexity for the Fed. Lucas: Yeah, the ECB move is a big deal. It tells you that inflation is a global problem, and central banks are forced to act even when growth is fragile. The UK economy actually shrank 0.1 percent in April. Luna: So the Fed is watching other central banks hike, while they're stuck wondering if they should do more. But the bond market seems to be pricing in a different story. Lucas: The yield curve has been inverted for a while, but now it's starting to normalize. The 10-year Treasury is at 4.47 percent, the 30-year at 4.97 percent. Short-term rates like the 2-year are lower. That's usually a sign that the market expects rates to come down. Luna: But if the Fed cuts rates now, with inflation at 4.2 percent, that would be a huge gamble. They'd risk letting inflation become entrenched. Lucas: Right. So the market might be wrong. Or they might be betting that the economy weakens enough to bring inflation down on its own. But so far, the data doesn't support that. Wholesale prices rose 1.1 percent in May, more than expected, driven by energy. Luna: That's the producer price index feeding through to consumer prices down the line. So the inflation pressure isn't letting up. Lucas: And then you have the consumer side. The CPI hit 334 index points in May, up from 332.4 in April. That's a 0.5 percent monthly increase, annualizing to about 6 percent. Not good. Luna: So the Fed is between a rock and a hard place. If they hike, they risk recession. If they hold or cut, inflation stays high. Lucas: And there's a third option: just wait. Keep rates where they are and hope that the lagged effects of past hikes eventually cool things down. But that's a bet, not a strategy. Luna: Speaking of bets, one thing that's interesting is the breakeven inflation rate. The 10-year breakeven is at 2.32 percent. That's what the bond market expects inflation to average over the next decade. It's actually below the current rate. Lucas: So the market thinks today's high inflation is temporary. But they've been wrong before. The Fed's own projections have been consistently too low. Luna: Right. And if the market is wrong again, the Fed will have to act more aggressively later. That's the risk of waiting. Lucas: Let's talk about what the Fed's actual tools are right now. The interest on reserve balances is at 3.65 percent, which is slightly above the fed funds rate. That's their main lever for controlling short-term rates. Luna: But that only works if banks are willing to lend. If they're hoarding reserves, the transmission mechanism is weaker. Lucas: Exactly. And we've seen bank lending tighten over the past year. The regional banking stress last year made banks more cautious. So even if the Fed keeps rates steady, credit conditions are already restrictive. Luna: So maybe the Fed doesn't need to hike more because the private sector is doing the tightening for them? Lucas: That's the argument for patience. But the JOLTS numbers suggest otherwise. If job openings are surging, employers are still confident enough to hire and invest. That's not a economy that's being restrained. Luna: And the stock market seems to agree. The S&P 500 is at 7,554, near all-time highs. The Dow is above 51,600. Markets are pricing in a soft landing, not a recession. Lucas: But the small-cap Russell 2000 is up 2.7 percent in the last five days, outperforming the large caps. That could signal a rotation into more cyclical, rate-sensitive stocks. Maybe investors think the Fed will cut soon. Luna: Or they're just chasing returns. Hard to tell. But the bottom line is the Fed has no easy path. Lucas: No easy path at all. And honestly, if walking through the economy with us has made something click, maybe consider showing some love. This show is ad-free and listener-supported, and even a small gesture helps keep it that way. Luna: Yeah, if today's episode was worth the price of a coffee to you, that's the link. Buy me a coffee dot com slash fexingo. Lucas: It really does make a difference. And it lets us keep digging into these questions without any outside pressure. Luna: Alright, back to the Fed. So what do you think they'll actually do at the next meeting? Lucas: I think they'll hold steady. The data is too messy to justify a hike, and cutting would be premature. They'll wait for more signs that inflation is either coming down or that the economy is weakening significantly. Luna: So a wait and see approach. But if inflation stays sticky, they'll eventually have to choose. Lucas: Right. And that choice will define the next phase of this cycle. Either they accept higher inflation for longer, or they risk a recession to crush it. There's no easy way out. Luna: And that's the macro memo for today. Thanks for listening.