Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Fed Is Stuck Between Inflation and Rate Cuts
Transcript
- Lucas: So the Fed is in a strange spot right now. Inflation is running at 4.2 percent annually, the effective fed funds rate is 3.63 percent, and yet the economy is growing at just 1.6 percent real GDP. That's a recipe for policy headaches. Luna: And the old rule of thumb — that the Fed funds rate should be above inflation — that's broken, right? Real rates are negative. Lucas: Exactly. Real fed funds rate is about negative 0.6 percent. That's not what you'd expect after the most aggressive hiking cycle in decades. Usually by this point, you'd have positive real rates squeezing demand. Instead, we're stuck. Luna: But the Fed hasn't cut. They've held at 3.63 percent since May. What's the argument for staying put when inflation is still double their target? Lucas: The argument is that the economy hasn't cracked yet. Unemployment is flat at 4.3 percent, job openings surged back to 7.6 million in April — up from 6.9 million in March. If you cut now, you risk pouring fuel on a fire that's already burning. Luna: Right, the JOLTS number was a shocker. Almost a million new openings in one month. That's not a cooling labor market. Lucas: No, it's not. And the May CPI print — 4.2 percent headline — was the highest in three years. So the data argues for patience. But the flip side is that growth is sluggish. Real GDP annualised is only 1.6 percent. If you hold rates here too long, you might tip the economy into recession. Luna: So it's the classic central banker's dilemma: too tight and you break something, too loose and inflation stays sticky. Where do you think the FOMC lands at the next meeting? Lucas: I think they hold again. The data just doesn't give them cover to cut. Core PCE is still above 3 percent — the April reading was 129.6 on the index, up from 129.32. That's a 2.8 percent annualised increase, which is still above target. And wholesale prices jumped 1.1 percent in May on energy costs. Luna: That ECB hike last week complicates things too. If the ECB is raising rates because of energy inflation from the Iran conflict, that puts upward pressure on the dollar and on import prices here. Lucas: Exactly. The ECB went for a hike — first since 2023 — and that strengthens the dollar, which should theoretically lower import inflation. But it also tightens global financial conditions. So the Fed has to factor that in. Luna: And the yield curve? We've been talking about inversion for months, but now the 10-year is at 4.49 percent, the 2-year is at 3.62 percent. That's a steeply inverted curve still. Lucas: Right, the 10-year minus 2-year spread is about 87 basis points inverted. That's still deep in recession-signal territory. But the economy keeps defying those predictions. The question is whether this time is different, or whether the recession is just delayed. Luna: Let's talk about the consumer. If inflation is eating into real wages, but the labor market is still adding jobs — average hourly earnings hit $37.50 in May — then households are treading water. Spending holds up, but savings deplete. Lucas: That's the narrative that bothers me. The consumer confidence data has been weak — we talked about that a few episodes back — yet spending data stays firm. The decoupling is real. And it means the Fed can't rely on consumer pullback to cool inflation. Luna: So what would actually break the stalemate? A sharper slowdown in hiring? A drop in energy prices? Or does the Fed just need to accept that inflation will take longer to come down? Lucas: I think the most likely path is that the Fed holds through the summer, and if we see a sustained softening in core services inflation — which is the stickiest component — they might cut once in the fourth quarter. But that's contingent on no new supply shocks. Luna: And the Iran situation is a wildcard. If energy prices keep rising, inflation could go higher before it comes down. Lucas: Exactly. The UK economy shrinking 0.1 percent in April — partly due to the conflict — shows this is a global issue. And the Chinese startup funding crackdown adds another layer of uncertainty for global supply chains. Luna: It's a lot of moving parts. I want to zero in on one number that I think sums up the Fed's bind: the 10-year breakeven inflation rate is 2.31 percent. That's up from 2.29 percent last week. The bond market is pricing in above-target inflation for the long run. Lucas: That's the key. The breakeven rate — which is the market's expectation for average inflation over the next decade — is above the Fed's 2 percent target. So even if the Fed cuts, the market doesn't believe inflation will stay low. That makes it harder for the Fed to ease without losing credibility. Luna: So what's your bottom line for our listeners? What should they watch in the next few weeks? Lucas: Watch the Fed's dot plot and the press conference after the next meeting — look for any change in the median rate path. Also watch jobless claims: if they break above 250,000 consistently, that's a sign the labor market is softening. And watch oil prices — that's the wildcard that could force the Fed's hand. Luna: And I'd add: watch the small-cap index. The Russell 2000 is up 3.1 percent over the past five days. That could be a signal that investors expect a pivot, or it could be a dead cat bounce. Lucas: Small caps are definitely pricing in a soft landing. But if the landing turns hard, they'll be the first to fall. Luna: You know, talking through this stuff episode after episode — I find it really helpful to clarify my own thinking. And I know our listeners do too. Lucas: Yeah, I feel the same. And one thing that keeps this show going — no ads, no corporate sponsors — is that a small group of listeners chips in to support it directly. If you've been getting value from these conversations, you can find us at buy me a coffee dot com slash fexingo. It's a simple way to keep the podcast ad-free and independent. Luna: Exactly. It makes a real difference. And we appreciate every single person who's already part of that community. Lucas: Anyway, back to the macro picture. I want to finish with a thought about what the Fed's next move says about the broader economy. If they hold, they're betting that the current slowdown is transitory. If they cut, they're acknowledging that the risks are tilted to the downside. Luna: And whichever way they go, the data we've been discussing — the CPI, the JOLTS, the GDP — that's what will drive the decision. Not politics, not market pressure. Just the numbers. Lucas: Right. And right now, the numbers say: stay patient. But we'll be watching every release between now and the next FOMC meeting. For The Macro Memo, I'm Lucas. Luna: And I'm Luna. Thanks for being here.