Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / How Warsh Navigates Fed Pressure as Inflation Cools
Transcript
- Lucas: So the Fed is stuck in this strange spot where the inflation numbers keep coming in cooler than anyone expected, but the manufacturing survey out this week shows price pressures that manufacturers say are worse than the pandemic era. That's a wide gap. Luna: Yeah, and it's not just a data noise thing. You've got the headline CPI down to 332.6, core PCE actually ticking up slightly. The Fed's own preferred gauge is barely moving. Lucas: Right. And that's the puzzle for Kevin Warsh's Fed. The 10-year breakeven inflation rate fell to 2.23 percent, which is below the Fed's target. Bond markets are basically saying inflation is not a problem going forward. But manufacturers are screaming about costs. Luna: And if walking through the economy with us has made something click, we'd appreciate it if you'd consider supporting the show. Buy me a coffee dot com slash fexingo. It's what keeps this ad-free and independent. Lucas: Yeah, a coffee helps. And speaking of breakevens, they've dropped from 2.27 to 2.23 in just a few days. That's a meaningful move, and it's happening while the Fed is on hold with the effective fed funds rate at 3.63 percent. Luna: But how much weight should we put on breakevens? They can be distorted by liquidity and safe-haven flows. Lucas: That's a fair point. But when you see the 10-year Treasury yield fall to 4.62 percent while the stock market rallies hard — the S&P 500 up over four percent in five days — that's not a market screaming about inflation risk. Luna: And yet manufacturing survey shows inflation worries worse than pandemic era. That's a direct quote from the headline. Sounds like a real disconnect. Lucas: It is. And the thing is, those manufacturing concerns are largely tariff-driven. If you're a manufacturer importing inputs, tariffs are a direct cost. That's not demand-pull inflation, that's a policy choice. And the Fed has to decide whether to look through it or respond. Luna: So what's the risk of overreacting to the manufacturing survey? I mean, manufacturing is a smaller part of the economy than services. Lucas: Right, it's maybe ten percent of GDP. But it's politically sensitive. And Warsh has been vocal about wanting to keep inflation expectations anchored. If manufacturers start passing on those costs, it could feed into broader inflation down the road. Luna: But the data doesn't show that yet. Core PCE is at 130.3, up just a hair from 130.09. That's basically flat. And the unemployment rate fell to 4.2 percent. Lucas: Exactly. The labor market is still solid. Nonfarm payrolls added about 57,000 jobs in June, and job openings are still above seven million, though they did pull back. But then you get the ADP report this morning showing just 44,000 private jobs added in July. That's a big miss. Luna: So is the labor market starting to crack, or is ADP just noisy? Lucas: ADP is noisy, but it's still a signal. Initial jobless claims ticked up to 197,000, though that's still historically low. The Fed is probably not panicking, but they're watching. Luna: And they're stuck because inflation is cooling, but not fast enough to cut, and manufacturing is screaming. Lucas: Precisely. The Fed's own communication has been about patience. They've been on hold since earlier this year, and the market is starting to price in a cut later this year, maybe September. But Warsh has been careful not to commit. Luna: Do you think he's more worried about inflation or a potential slowdown? Lucas: That's the million-dollar question. On one hand, he's got the inflation hawks in his ear, and the manufacturing survey gives them ammunition. On the other, if GDP growth is slowing — real GDP grew at just one and a half percent annualized last quarter, down from two point one — he can't ignore that. Luna: And with the yield curve steepening, the 10-year at 4.62 and the 2-year at 3.73, that's a pretty wide spread. Historically that's been a sign of growth expectations, not recession. Lucas: Right, a steepening curve usually means the market expects stronger growth and maybe higher inflation ahead. But here, long-term yields have actually fallen while short-term yields have risen. That's a bit unusual. It's more like the market is pricing in a Fed that stays tight for too long. Luna: So the bond market is saying 'you might break something.' Lucas: Exactly. And that's the tension. The Fed wants to avoid a policy mistake. If they cut too soon and inflation re-accelerates, that's bad. If they hold too long and the economy rolls over, that's also bad. Warsh has to thread that needle. Luna: What about the China factor? Their factory activity unexpectedly contracted in July, and that's not helping global growth. Lucas: That's a wildcard. If China slows, that could put downward pressure on commodity prices and global inflation, which actually helps the Fed's case for cutting. But it could also hit US exports and manufacturing sentiment further. Luna: And the drought in Europe? Riverbeds blowing up? That sounds like it could disrupt supply chains and push food prices up. Lucas: Yeah, that's another supply shock. And it's the kind of thing that could show up in the inflation data a few months from now. But it's not something the Fed can react to preemptively. They have to wait and see. Luna: So bottom line: the Fed is in a waiting game, but the pressure is building from multiple sides. Lucas: Right. And the next few weeks are crucial. We'll get the July jobs report, which will be a big deal after the ADP miss. And then the FOMC meeting in September, where they'll have to signal something. The market is already pricing in a cut. Luna: And what would change Warsh's mind? A clear softening in the labor market or a significant drop in core PCE? Lucas: Probably a combination. If unemployment ticks up above four and a half percent and core PCE shows a sustained decline toward two percent, he'd have cover to cut. But if inflation stays sticky and manufacturing keeps complaining, he can stay on hold and point to the data. Luna: It's a delicate balance. And the market is hanging on every word. Lucas: It always is. But the thing is, Warsh has been pretty consistent about his framework. He's focused on the medium-term outlook, not the monthly noise. So even with the ADP miss, I don't think he's going to jump. Luna: So we're back to patience. Lucas: Yeah. Patience, with a close eye on the data. And the data is giving mixed signals. That's the reality of this moment. Luna: And as always, we'll be watching. Thanks for joining us. Lucas: And we'll see you next time on The Macro Memo.