Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / Why the Fed's Preferred Inflation Gauge Hit Its Highest Since 2023
Transcript
- Lucas: So yesterday the Bureau of Economic Analysis dropped the April PCE numbers, and the core reading — that's excluding food and energy — hit 3.4 percent year-over-year. That's the highest since October 2023. Luna: And this is the Fed's preferred inflation gauge, not the CPI we usually talk about. Lucas: Exactly. The Fed targets PCE, not CPI. And 3.4 percent is well above their 2 percent target. The market reaction was telling — the S&P 500 dropped about 1.4 percent over the last five days, and the Nasdaq fell nearly 3 percent. Luna: So investors are pricing in that rate cuts just got pushed further out. Lucas: Right. The fed funds rate is sitting at 3.63 percent, and the interest on reserve balances is 3.65 percent. The market had been hoping for a cut by September, but this PCE print makes that look unlikely. Luna: Let's unpack what's actually in the PCE. What's driving that 3.4 percent? Lucas: Two main forces. First, services inflation remains sticky. Things like housing, health care, financial services — those categories are still running hot. The core services ex-housing, which the Fed watches closely, is actually accelerating. Luna: So the services side isn't cooling off the way goods did last year. Lucas: That's the second piece — goods disinflation is fading. Last year, goods prices were actually falling, which helped pull down headline inflation. But now that's reversing. Supply chains have normalized, but demand is still there, and some input costs are rising. Luna: And then there's energy. The headline PCE came in at 3.5 percent, partly because energy prices ticked up. We've got the Strait of Hormuz situation — a U.S.-Iran deal was signed last week, but the UN just paused its ship evacuation plan after a vessel was attacked. So oil markets are on edge. Lucas: Yeah, that's a wild card. Gold fell 2.2 percent this week, silver dropped over 9 percent — investors are repositioning. But back to PCE: the 10-year breakeven inflation rate, which is a market-based measure of expected inflation, ticked up to 2.21 percent. That's still anchored, but it's moving in the wrong direction. Luna: So the bond market is saying inflation will average above 2 percent for the next decade. Lucas: Correct. And that puts the Fed in a tough spot. If they cut rates while core PCE is at 3.4 percent, they risk losing credibility. But if they hold rates here, the economy could slow more than expected. The May CPI came in at 334.0, up from 332.41, so that's also running hot. Luna: One thing I find confusing — CPI and PCE often tell different stories. Can you explain why the Fed prefers PCE? Lucas: Sure. PCE covers a broader range of goods and services, and it accounts for substitution — when consumers switch from pricier beef to cheaper chicken, PCE captures that. CPI uses a fixed basket. Also, PCE weights are updated more frequently, so it's more responsive to real spending patterns. Luna: So PCE is considered more accurate for what people actually spend, rather than a fixed basket. Lucas: Exactly. But that also means it can be slower to show inflation when it's coming from new categories. The Fed knows this, which is why they look at both. But their policy decisions are explicitly tied to PCE. Luna: So what does this mean for someone listening, like a household trying to budget? Lucas: Practically, it means the cost of services — rent, insurance, medical care — is still rising faster than overall inflation. If you're a renter, your lease renewal is probably going up more than the 3.4 percent headline. And with rates staying higher for longer, mortgage rates aren't coming down soon. Luna: That's the real-world bite. It's not just an academic number. Lucas: Yeah. And if you look at the breakdown, the stickiness in services is partly due to labor costs. Wages are still growing around 4 to 5 percent, which feeds into service prices. That's a feedback loop the Fed can't easily break without causing unemployment to rise. Luna: So we're in this kind of equilibrium where inflation is above target, but the economy isn't collapsing. The Fed is walking a tightrope. Lucas: That's exactly right. And the June FOMC meeting is in two weeks. The market is pricing in no change. But the tone of the statement will matter — if they sound more worried about inflation, that could rattle markets further. Luna: Before we move on — if this kind of breakdown is useful to you, these episodes stay ad-free thanks to listener support. You can find us at buy me a coffee dot com slash fexingo. Just a way to keep the economics conversation going without any sponsor noise. Lucas: Really appreciate that. And it does make a difference. So, back to the PCE — one more nuance: the core PCE index level hit 130.1, up from 129.67. That's a 0.33 percent month-over-month increase. Annualized, that's nearly 4 percent. Luna: So if you annualize the monthly pace, it's even worse than the year-over-year number. Lucas: Exactly. That's why the Fed is cautious. They don't want to declare victory too early. The last mile of getting inflation down to 2 percent is proving to be the hardest. Luna: And what about the goods side? Is there any chance of disinflation coming back? Lucas: Maybe, but it's uncertain. Used car prices have been falling, and that helped CPI recently. But new car prices are still elevated. And with potential tariffs or supply chain disruptions from geopolitical events — like the Hormuz situation — goods prices could spike again. Luna: So we're back to the uncertainty theme. The Fed's favorite gauge says inflation is still too high, and the path forward depends on factors outside their control. Lucas: Right. And that's the story for this summer. We'll get the May PCE data in late July, and that'll be a key data point before the September meeting. If it stays above 3 percent, a 2026 rate cut is off the table. Luna: Thanks for breaking that down. It's a lot to digest, but knowing which number the Fed actually watches helps cut through the noise. Lucas: Glad it helped. We'll keep tracking it as the data comes in.