Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Fed Watches Core PCE While CPI Cools
Transcript
- Lucas: So the headline this week is that the Fed's favorite inflation gauge just did something odd — it ticked up, even as the CPI everyone watches kept cooling. The core PCE price index rose to 130.3 in June, up from 130.09 the month before, while core CPI actually fell slightly. And that divergence is the kind of thing that makes a central banker pause. Luna: Wait, I thought inflation was coming down across the board. How can one measure go up while the other goes down? Lucas: That's the question, and it's not just academic. The Fed has said for years that PCE is its preferred measure — it's broader, it captures how people actually substitute when prices rise. So when core PCE creeps up while CPI cools, the message to the Fed is a bit murkier than the headlines suggest. Luna: So the market's reading of 'inflation is solved' might be premature? Lucas: Exactly. And look at the market data from this week — the ten-year breakeven rate is at 2.27 percent, actually down a hair from last week. So bond traders are betting on lower inflation ahead, but the core PCE number is the one the Fed can't ignore. It's the measure that's been sticky all year. Luna: Sticky even with the unemployment rate down to 4.2 percent and payrolls still growing? Lucas: Right, and that's the puzzle. You've got a labor market that's still adding jobs — nonfarm payrolls up to almost 159 million — but job openings are falling, down to 7.36 million from 7.54 million. That's a sign that the demand for workers is cooling, yet core inflation isn't cooperating. Luna: So is the Fed stuck between a cooling job market and a stubborn inflation measure? Lucas: That's the bind. The FOMC has held the funds rate at 3.63 percent since the spring, and they're clearly in no rush to cut. But with a divided Fed — you saw those headlines about 'what a divided Fed means' — there's real debate about whether they should ease to support the job market or hold the line on inflation. Luna: And the bond market is sending mixed signals too, right? The two-year yield is up, the ten-year is down. Lucas: Yeah, the yield curve is steepening again, which is usually a sign that investors expect growth and inflation to pick up. But the breakeven rate says the opposite. So the market itself is divided, just like the Fed. Luna: So when we hear 'core PCE rose,' how much should we actually worry? Lucas: Let's break that apart, because the move is tiny — we're talking tenths of a point. But the direction matters. Core PCE has been hovering around 3.3 percent for months, while the Fed's target is 2. The gap is narrowing, but it's still a gap. And the reason core PCE is sticky is partly a measurement thing — it weights things like housing and healthcare differently than CPI does. Luna: Ah, so the PCE number might not be as bad as it looks at first glance. Lucas: Right. For example, PCE uses a different formula for rental costs — it captures the actual market rents people are paying, while CPI uses a survey of what owners think their homes would rent for. And this year, market rents have been slowing, but the CPI measure has been slower to catch up. So the PCE number might be more accurate, but it's also more volatile in the short term. Luna: So the Fed is looking at a number that's arguably more accurate but harder to move. Lucas: Exactly. And that's why they keep saying they need 'more confidence' before they cut. They're not going to chase a couple of good CPI prints if their preferred gauge is still running above target. Luna: But what about the jobs side? Job openings are down, unemployment is low but creeping up — doesn't that argue for a cut? Lucas: It does, and that's the tension. The Fed has a dual mandate — price stability and maximum employment. When you see job openings falling, that's usually a leading indicator of a softer labor market. But the Fed has been clear that they'll tolerate some cooling in jobs if it means getting inflation down. The question is how much cooling. Luna: And the latest jobless claims are at 197,000, up from 188,000 the week before. That's a jump, isn't it? Lucas: It's a notable uptick, but it's still historically low. The labor market isn't collapsing; it's just normalizing. And that's the tricky part for the Fed — they don't want to cut too early and reignite inflation, but they also don't want to wait too long and tip the economy into a recession. Luna: So what does this mean for the average listener who's watching their savings account yield? Lucas: Well, if the Fed stays on hold, short-term rates stay put. Money market funds and high-yield savings accounts are still paying decent rates — around 4 percent or more. But if the Fed does cut, those yields will start to slide. So the bet you're making is whether the Fed is more worried about inflation or jobs. Luna: And that's the million-dollar question. So, before we dig into what a divided Fed means for investors, I want to mention something that's been on my mind. You know, we keep the show ad-free, and that's only possible because of our listeners. If you get value out of these conversations, consider supporting us at buy me a coffee dot com slash fexingo. It's a small gesture that keeps us going. Lucas: Yeah, we really appreciate that. It's what lets us keep having these nerdy macro conversations without any corporate interruptions. And if you can't, no worries — just being here is enough. Luna: Exactly. Alright, back to the Fed. So we've got a divided Fed — what does that actually mean for investors? Lucas: It means you should expect volatility in bond markets, and possibly in equities, because every data point becomes a referendum on which way the committee will lean. The markets are already pricing in a certain path, but if core PCE stays sticky, you could see rate expectations shift. Luna: And that's why the stock market had such a big week? The S&P is up almost 6 percent in five days. Lucas: Yeah, but that rally was more about earnings and a soft-landing narrative. The point is, the Fed's internal debate is the background noise that can change the tune at any moment. If you're invested, you want to watch the core PCE releases more than the CPI headlines, because that's the one the Fed actually acts on. Luna: So for our listeners, what's the one thing to remember from today? Lucas: Don't panic over a single month's core PCE uptick, but don't assume inflation is dead either. The Fed is data-dependent, and the data is pointing in two directions at once. Watch the breakeven rates — they're a real-time signal of what the market expects. Luna: And what about the yield curve steepening? Does that tell a different story? Lucas: A steeper curve usually means investors expect stronger growth or higher inflation down the road. But with the breakeven falling, it might just be a term premium — investors demanding more compensation for holding long-term bonds. Either way, it's a sign that the market isn't fully aligned with the Fed's baseline. Luna: So we're in a wait and see mode until the next CPI or PCE print. Lucas: Absolutely. And the next FOMC meeting — they've been holding at 3.63 percent, and I think they'll keep holding until they see a few more months of cooling in core PCE. But if jobless claims keep rising, that could change the calculus. Luna: So the labor market is the wildcard. Lucas: It always is. The Fed's own projections showed a 4.2 percent unemployment rate for this year, and we're right there. If it goes higher, the dual mandate tilts toward easing. If it stays put, inflation takes the lead. Luna: And that's the balancing act. Thanks for breaking this down, Lucas. I think I finally understand why the Fed isn't celebrating the CPI numbers. Lucas: Happy to help. The macro picture is always more nuanced than a headline, and that's what we're here for.