Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Core PCE Surprise
Transcript
- Lucas: So the Fed's preferred inflation gauge just came in hotter than expected. Core PCE rose three-tenths of a percent in July, and that pushed the annual rate to three point three percent. That's not exactly the two percent the Fed is aiming for. Luna: And this is the one they actually pay attention to, right? The PCE deflator, not the CPI. Lucas: Exactly. The Fed's mandate is framed around the PCE index. It's the one they forecast in their Summary of Economic Projections. So when core PCE comes in above the whisper number, the market listens. Luna: The whisper number being around two-tenths, I take it. So three-tenths is a meaningful beat to the upside. Lucas: Right. And it's not just one month. The core PCE index has been running at a pace that annualizes to around three percent for the past few months. It's sticky. That's the word you hear from Fed officials again and again. Luna: Sticky inflation. That's the reason the Fed has kept rates where they are, even as the market has priced in a few cuts by next year. Lucas: And the market keeps having to adjust. Right now, the two-year Treasury yield is around four point seven three percent, up half a percent over the last five days. That's the market repricing the odds of a cut sooner rather than later. Luna: And the ten-year is at four point four nine, so we've got a deeply inverted curve. That's usually a sign the market thinks the Fed will need to cut at some point. Lucas: But the Fed is pushing back on that narrative. You've got Warsh, the Chair, talking about being 'quieter' — meaning less forward guidance — and Hammack saying 'now is the time to act' on rate hikes. That's a hawkish tilt. Luna: So the Fed is essentially saying, we're not done yet, even as the market is pricing in cuts. There's a disconnect. Lucas: That disconnect is exactly what we're going to unpack today. How does the Fed read this core PCE surprise, and what does it mean for the path of rates? Luna: Let's start with the data itself. Core PCE at three point three percent annual. That's up from three point two percent in June. And the monthly gain was three-tenths, after two-tenths in June. So it's accelerating. Lucas: It is. And what's driving it? Not just goods — services are the big one. Housing, healthcare, insurance. Those categories are slow to adjust, and they're keeping the core index elevated. Luna: So this isn't a transitory blip. It's a persistent trend that the Fed has to take seriously. Lucas: And that's why the Fed's preferred measure matters more than the CPI. The CPI has been running a bit cooler, around two point eight percent. But PCE captures more of what consumers actually spend, and it's weighted differently. So the Fed isn't popping champagne over the CPI. Luna: Right. And one of the things I find interesting is that the effective fed funds rate is sitting at three point six three percent, but the interest on reserve balances is three point six five. That gap is tiny. Lucas: That's the Fed's control mechanism. They pay banks that rate on their reserves, and that anchors the fed funds rate in a narrow range. As long as that corridor holds, the Fed can steer short-term rates without having to buy or sell securities constantly. Luna: But we've seen strains in the repo market in the past. Remember 2019? The Fed had to step in. Lucas: And that's why they've built new tools since then — the standing repo facility, the overnight reverse repo facility. They're there to keep the fed funds rate inside the target range even when the balance sheet is shrinking. Luna: So the balance sheet runoff — the so-called quantitative tightening — is still going on. But the Fed is being careful not to let it tighten financial conditions too much, because inflation is still above target. Lucas: Exactly. They're walking a tightrope. On one hand, they want to keep pressure on inflation. On the other, they don't want to cause a liquidity crunch that would force them to reverse course. Luna: And that's why the two-year yield is so closely watched. It's the market's guess at where the Fed will set rates over the next couple of years. Lucas: And right now, that guess is that the Fed will eventually cut, but not anytime soon. The two-year at four point seven three implies that the market sees the first cut maybe in the second half of next year. Luna: But the Fed's own projections have been showing fewer cuts than the market. So someone is going to be wrong. Lucas: That's the classic policy error debate. If the Fed keeps rates too high for too long, they risk overshooting on the downside — a recession. If they cut too early, inflation stays stuck above target. Luna: And this core PCE number complicates things. It doesn't give the Fed much cover to cut. Lucas: Not at all. In fact, if anything, it strengthens the case for another hike. Hammack was pretty blunt about that. Luna: But hasn't the Fed been trying to move away from forward guidance? Warsh said he wants a 'quieter' Fed, right? Lucas: He did. And that's a real shift in communication style. The idea is that the Fed shouldn't telegraph every move, because that can create market volatility. But it also means the market has to guess more, which can be just as volatile. Luna: So we're in this weird place where the Fed is trying to be less predictable, but the data is pulling them toward more action. Lucas: And that's what makes this episode so relevant. If core PCE stays at three percent or higher, the Fed might have to hike again, even if the market isn't expecting it. That's a big deal for bond markets, equity markets, mortgages — everything. Luna: So what should listeners be watching next? What's the key data point that could tip the scales? Lucas: The next jobs report, for one. If wage growth accelerates, that adds to the inflation pressure. And the next core PCE reading in a month. But also watch the Fed's own communications — any hints from the Chair or other members about their reaction function. Luna: And for anyone following the market, the two-year yield is a good real-time gauge of how the market is adjusting to all this. Lucas: Absolutely. If the two-year starts pushing toward four point eight or higher, that's the market pricing in a higher path for rates. Luna: And if it drops below four point five, that's the opposite — the market smelling a cut. Lucas: Right. So keep an eye on that. For now, the Fed is in a patient, data-dependent mode, but this core PCE print gives them less reason to be patient. Luna: And before we wrap up, I want to mention that this show is ad-free and listener-supported. If you've gotten something out of these episodes, a couple of dollars a month makes a real difference. You can support us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it genuinely helps keep the lights on and lets us keep digging into these topics. Even a small contribution goes a long way. Luna: And back to the Fed — the bottom line is that the core PCE surprise doesn't change the Fed's immediate path, but it does sharpen the debate around the next move. Lucas: So the question going forward is whether this is a one-month blip or the start of a trend. If it's the latter, the Fed may have no choice but to act. We'll be watching.