Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Keeps a Window Open to Rate Hikes
Transcript
- Lucas: So the July CPI report lands, and the headline comes in at 3.4 percent annual. That's exactly what the market expected. But here's what caught my eye: the ten-year breakeven, which is the market's own inflation expectation, actually ticked down to 2.27. The Fed is looking at that and thinking, okay, long-term expectations are anchored, but short-term inflation is still running hot. Luna: Right, and the Fed funds rate is sitting at 3.63, flat for over a month now. So we've got this disconnect between where the rate is and where inflation is. I mean, 3.4 percent is still above their 2 percent target. Lucas: Exactly. And that's why the Fed's language has been so careful. They've been using the word 'adjustment' instead of 'cut' when they talk about future moves. That's a deliberate choice. They want to keep the door open to a hike if inflation surprises to the upside, even though the market is pricing in a cut by year-end. Luna: But isn't that just semantics? If they cut, it's a cut, regardless of what they call it. Lucas: It's more than semantics. The word 'adjustment' implies it could go either way. A 'cut' is one-directional. And the Fed has been burned before by telegraphing a path and then having to reverse. Remember 2021, when they called inflation 'transitory'? They don't want to repeat that mistake. Luna: So they're basically managing expectations with vocabulary. But what about the two-year yield? It's been creeping up, and that usually signals the market expects tighter policy, not looser. Lucas: That's a great point. The two-year yield is at 3.70, up slightly over the past week. And that's a puzzle for the Fed. On one hand, they want to signal they're not done fighting inflation. On the other, a rising two-year yield tightens financial conditions on its own, which might be doing some of their work for them. Luna: So the market is kind of doing the Fed's job by pushing yields higher? That seems counterintuitive when they're supposed to be the ones setting policy. Lucas: It's a delicate balance. The Fed sets the short-term rate, but the market influences longer-term rates, and that's what affects borrowing costs for businesses and households. So if the two-year yield is rising because the market expects the Fed to stay hawkish, that helps tighten conditions. But if it's rising because of inflation fears, that's a warning sign. Luna: And right now, which is it? Lucas: Hard to say. But the fact that breakevens are falling suggests the market isn't panicking about long-term inflation. So the rise in the two-year is probably more about near-term policy expectations. The Fed might be okay with that. Luna: Still, it must be awkward for the Fed to have to talk about rate hikes when the economy is slowing. The GDP numbers have been soft, haven't they? Lucas: They have. But the Fed's dual mandate is price stability and maximum employment. And so far, the job market hasn't fallen apart. The July jobs report showed wage growth that's still too high for their liking. So they're in this holding pattern, waiting for more data. Luna: Hmm. And what about the budget deficit? We just saw that headline about July's surplus deficit surge, the highest since March 2021. Does that complicate things? Lucas: It does, indirectly. A bigger deficit means more Treasury issuance, which adds to supply. That puts upward pressure on yields, especially at the long end. And that can feed into mortgage rates and corporate borrowing costs. The Fed doesn't control that directly, but they have to be aware of it. Luna: So it's like a double whammy: the Fed is trying to tighten, and the fiscal side is doing the same through higher yields. That could actually help bring inflation down faster. Lucas: In theory, yes. But it also makes it harder for the Fed to cut if the economy weakens, because the fiscal situation might keep long rates elevated. So they have to be cautious about looking too dovish. Luna: Let's talk about the elephant in the room: AI and data centers. I saw a headline that said the AI build-out is complicating the Fed's inflation fight. How so? Lucas: That's a fascinating angle. Data centers are massive energy consumers, and they're driving up demand for electricity and construction. That's showing up in services inflation, which is stickier than goods. So even if goods prices are cooling, services are keeping inflation elevated. Luna: So the Fed is having to factor in a technology-driven demand shock that wasn't on their radar a few years ago. Lucas: Exactly. And it's not just energy. It's also the construction of these facilities, the specialized equipment, and the labor to build them. All of that is feeding into producer prices and eventually consumer prices. The Fed has to consider whether this is a temporary blip or a longer-term shift. Luna: That's a tough call. So they're basically in a wait and see mode, but with a hawkish tilt. Lucas: Right. And that's why the FOMC minutes, which come out later this month, will be so closely watched. Investors will be parsing every sentence for clues about the 'adjustment' debate. If there's any mention of the word 'hike' in the discussion, the market could react strongly. Luna: So what should listeners look for in those minutes? Lucas: Look for how they describe the balance of risks. If they emphasize upside risks to inflation, that's hawkish. If they talk about downside risks to growth, that's dovish. Also, pay attention to any discussion of the neutral rate. That's been a hot topic this year, and it's directly relevant to whether they have room to cut. Luna: And in the meantime, the market is pricing in a cut by December. Is that realistic? Lucas: It's possible, but the Fed is going to need to see a string of softer inflation prints, especially in core services. If the CPI data over the next few months shows continued progress, they might feel comfortable easing. But if it stalls, they could hold rates higher for longer. Luna: So we're back to that word again: patience. Lucas: Patience, but with a hawkish tilt. And speaking of patience, this is a good time to mention that our show is ad-free, and that's thanks to listeners who support us. If you get value from these deep dives into the Fed's thinking, and you want to help us keep going, you can buy me a coffee at buy me a coffee dot com slash fexingo. It's a small way to help us keep the lights on. Luna: Yeah, we really appreciate it. It's what keeps us independent. Lucas: So, back to the Fed. There's another factor that's been on the Fed's radar: the recent plunge in lettuce prices. That might sound trivial, but it's a reminder that food prices can be volatile and can skew the inflation data. The headline CPI was held down partly by a drop in food prices. Luna: Interesting. So while the Fed focuses on core inflation, those food swings can still affect the headline number and influence public perception. Lucas: Exactly. And that's why they emphasize core inflation, which strips out food and energy. Core CPI is still running at 3.4 percent, and that's what the Fed really cares about. So even if the headline looks better, the underlying trend is still above target. Luna: So the bottom line is: the Fed is in a tight spot. They want to avoid a recession, but they also need to get inflation down. And they don't want to make the same mistake of declaring victory too early. Lucas: That's the crux of it. And that's why they're keeping that window open to rate hikes. It's a way to maintain credibility. If they close that window and then have to reverse, they lose faith from markets. So they'll likely keep using language that leaves all options on the table. Luna: So what would need to happen for them to actually hike? A big surprise in inflation, right? Lucas: Yes, a significant upside surprise in core inflation, maybe a big jump in wages, or a supply shock that could push prices up sharply. But as of now, the data doesn't point that way. It's more of a tail risk. Luna: So it's really about keeping the door open, not necessarily walking through it. Lucas: Exactly. And that's a subtle but important distinction. The Fed is mastering the art of saying a lot without saying anything too specific. The minutes will be our best window into their thinking. Luna: Well, we'll be watching. Thanks for breaking it down, Lucas. Lucas: Anytime, Luna. And if you're enjoying these episodes, remember to check out buy me a coffee dot com slash fexingo. It helps us keep the analysis coming.