Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Let Inflation Run Hot
Transcript
- Lucas: Let’s start with a number that has been driving every headline since last spring: two point five percent. That is the Federal Reserve’s official inflation target, anchored in their dual mandate alongside maximum employment. But here is the thing most people miss when they read the news — the Fed isn’t just trying to hit two point five percent exactly every single quarter. They are actively allowing inflation to run hot for extended periods if it means avoiding a recession. Luna: So you are saying the current tolerance for higher prices is actually by design, not a failure of control? I always assumed they were chasing that exact number like a bullseye. Lucas: Exactly. It is a deliberate shift away from what we used to call symmetric targeting. For decades, central banks treated any deviation above or below the target as equally bad. If inflation was at three percent, they tightened aggressively. If it was at one percent, they eased. The logic was that price stability meant zero variance. But looking at the data from the post-pandemic recovery, that rigid approach seems to have caused more harm than good. Luna: Right, because tightening too hard kills jobs. Is that the new priority? Lucas: It is about asymmetry. When inflation spikes due to supply shocks, like we saw in twenty twenty-one and twenty twenty-two, raising rates immediately to crush it risks crashing the housing market and triggering mass layoffs. The Fed realized that letting inflation sit at three or four percent for a year or two is cheaper politically and economically than causing a sharp unemployment spike. They are trading short-term price volatility for long-term labor market stability. Luna: That sounds like they are prioritizing workers over shoppers. Does the public actually accept that trade-off? Lucas: The public certainly doesn’t feel like they accepted it when they go to the grocery store. But look at the labor data. Unemployment stayed remarkably low despite inflation running well above two point five percent for eighteen months. In previous cycles, similar inflation levels would have triggered a recession within twelve months. This time, the labor market absorbed the shock because the Fed held back on aggressive hiking until mid-twenty twenty-three. Luna: So the soft landing wasn’t luck; it was patience? They waited for the pain to show up elsewhere first. Lucas: Precisely. And now we are seeing the formalization of this view. In late twenty twenty-five, several major central banks, including the ECB and the Bank of England, updated their frameworks to explicitly allow for overshooting the target. They acknowledged that hitting two point five percent exactly is nearly impossible in a volatile world, and trying to do so creates unnecessary economic friction. Luna: I remember reading about the ECB update. They called it average inflation targeting, right? But it feels different now. Lucas: Average inflation targeting was the first step, but this is deeper. Average inflation targeting meant making up for past misses. If you undershot by one percent last year, you overshoot this year. What we are seeing now is a structural tolerance. They are okay with being wrong about the path, as long as the outcome isn’t catastrophic. It changes how they react to daily CPI prints. Luna: Does that mean we should stop watching monthly CPI so closely? It feels like noise if they don't care. Lucas: You still watch it, but you interpret it differently. A single month of high inflation doesn’t trigger panic anymore unless it shows a second-wave acceleration. The Fed looks at core services excluding housing, which has been sticky around three percent. They know that wage growth supports that level. If wages weren’t rising, three percent inflation would be dangerous. But with real wage gains holding steady, it is manageable. Luna: So wage growth is the anchor keeping them calm. What happens if wages start slowing down while prices stay high? Lucas: That is the nightmare scenario for policymakers. Stagflation. If real wages start falling, consumer spending collapses, and then they have to choose between saving jobs or saving prices. Historically, they choose prices, and the pain is severe. That is why they monitor the Atlanta Fed’s wage tracker so closely. As long as nominal wages rise faster than headline inflation, they feel safe letting prices run. Luna: But nominal wages are starting to decelerate in some sectors. Tech layoffs come to mind. Doesn't that change the equation? Lucas: It does, but the broader economy is diversified. Tech is capital-intensive, not labor-intensive in the same way retail or hospitality is. The service sector is still hiring. The key metric here is the unemployment rate relative to the natural rate. If unemployment stays near four percent, the labor market has room to absorb price pressures without collapsing. Luna: Four percent is still historically low though. Aren't they risking overheating by keeping rates where they are? Lucas: They are walking a tightrope. Current interest rates are restrictive, but not overly so. The neutral rate — the rate that neither stimulates nor restricts the economy — has likely risen to around three percent. So when the Fed keeps the fed funds rate around four to four point five percent, they are providing just enough restraint to cool demand without killing growth. It is a precise calibration. Luna: And if they cut too fast, inflation comes roaring back. If they hold too long, we get a recession. Is there really no margin for error? Lucas: There is margin, but it is shrinking. The lag effect of monetary policy is still working through the system. Rate hikes from two years ago are still impacting commercial real estate and small business lending today. The full cost hasn't even been felt yet in some sectors. So cutting rates prematurely could ignite inflation again before the cooling effects fully materialize. Luna: That makes me nervous about my own investments. If rates stay high for longer, equities usually suffer. Are we ignoring that risk? Lucas: We are not ignoring it. High rates compress valuation multiples, especially for growth stocks. But corporate earnings have remained resilient because companies cut costs and improved margins rather than relying on cheap debt. The S&P fifty hundred is hitting highs not because rates are low, but because productivity is growing. AI adoption is boosting output per worker, which offsets the drag of higher borrowing costs. Luna: So productivity is saving us from the high-rate environment. That is a counterintuitive take. Most people think high rates always kill growth. Lucas: Traditionally, yes. But when you combine tight labor markets with rapid technological efficiency gains, you can sustain growth even with expensive money. The danger zone is if productivity stalls. If AI hype fades and output growth slows, then high rates will definitely cause a downturn. We are currently in the optimistic phase of that dynamic. Luna: Optimistic but fragile. How much of this depends on energy prices staying stable? Lucas: A huge amount. Energy is the wildcard. If oil spikes due to geopolitical conflict, inflation jumps instantly, and the Fed loses its flexibility. They would have to hike rates sharply regardless of the labor market. Right now, energy prices are relatively benign, giving them breathing room. But we cannot assume that continues indefinitely. Luna: So the strategy is working, but only if nothing else breaks. It feels like we are waiting for the other shoe to drop. Lucas: That is the reality of macroeconomics. You manage probabilities, not certainties. The current approach gives us the best shot at a soft landing. It accepts imperfection in exchange for stability. The alternative is returning to the Volcker era of crushing inflation with massive job losses. No central banker wants to go back there. Luna: Volcker was ruthless. He didn't care about politics. Why wouldn't the Fed just be tough again if inflation gets out of hand? Lucas: Because the political cost is too high. Governments depend on employment data for legitimacy. If unemployment hits six percent, the administration faces massive backlash. The Fed operates independently, but they are embedded in a democratic system. They have to balance their mandate with the social contract. Crushing inflation at the cost of widespread hardship is no longer a viable option. Luna: So democracy forces softer landings. Even if it means higher inflation averages. Interesting. Lucas: Exactly. We are living in a new regime. One where price stability is shared with employment stability. It is messier, but potentially more sustainable for the long term. The question for investors is whether they can adapt their portfolios to this new normal of moderate inflation and steady growth. Luna: Adapting to moderate inflation means expecting lower nominal returns. Bonds become less attractive, equities face pressure. Where do you put cash now? Lucas: Short-term treasuries still offer decent yields with low risk. Money market funds are paying around four percent. It is not exciting, but it preserves capital while you wait for better opportunities. Long-duration bonds are risky until we see clear signs of disinflation. Cash is king until the trend is undeniable. Luna: Preservation over aggression. That makes sense given the uncertainty we discussed. Lucas: For now. Once the Fed starts cutting and inflation confirms it is moving toward two point five percent, then you rotate into longer assets. But we are not there yet. Patience is the best strategy. Luna: Patience is hard when everyone else is talking about the next big breakout stock. Do you think retail investors are losing faith in this cautious approach? Lucas: Some are. They want action, not nuance. But the data doesn't lie. Markets that bet against the Fed’s ability to engineer a soft landing have been wrong repeatedly. The lesson here is to trust the process, not the headlines. Slow and steady wins the race, especially when the stakes are your retirement savings. Luna: Slow and steady. I guess that applies to our listening habits too. Thanks for keeping it grounded, Lucas. Lucas: Anytime. Let’s talk about how to keep this show running smoothly. Luna: If following these economic shifts with us has helped you navigate your own financial decisions... Lucas: consider supporting the show directly. It keeps the research ad-free and ensures we can keep digging into these complex topics for you. You can find us at buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. Luna: Every bit helps keep the lights on and the analysis sharp. Back to the markets. Lucas: Let’s look at the housing market, which is finally responding to those higher rates we mentioned earlier. Luna: Home sales are dropping, but prices haven't crashed yet. What is driving that resilience? Lucas: Supply shortage. There are fewer homes for sale than there were five years ago. Even with higher mortgage rates, buyers have no choice but to compete for limited inventory. It is a classic supply-side constraint overriding demand-side weakness. Luna: So affordability is terrible, but sellers won't drop prices. Is that sustainable? Lucas: Only until rents rise enough to make buying attractive again, or until a wave of equity-rich homeowners decide to sell. We are approaching a tipping point. When that happens, prices could correct faster than anyone expects. Keep an eye on listing volumes. Luna: Listing volumes. Got it. One more signal to watch alongside the Fed. Lucas: Exactly. The pieces are all connected. Rates, wages, housing, inflation. Watch the links, not just the nodes. Luna: Links over nodes. I’ll take that to heart. See you next time, Lucas. Lucas: See you. And remember, in a world of noise, clarity is the ultimate advantage.