Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Fed Is Cutting Rates Despite Sticky Core Inflation
Transcript
- Lucas: So the market is now pricing in a near-certainty of a rate cut at the June FOMC meeting. That is remarkable, because just yesterday we got the April core PCE print — 3.3 percent annualized, exactly as expected, but still well above the Fed's 2 percent target. Luna: Right, it feels like the market is almost ignoring the inflation number. What changed? Lucas: It's not ignoring it exactly. It's reading the Fed's own signals. The April minutes from the May meeting, which came out last week, showed a real shift in tone. Multiple participants noted that if the economy weakens further, they'd be prepared to ease — even with inflation still elevated. Luna: So they're basically saying we'll accept higher inflation to avoid a recession. Lucas: That's one way to put it. But I think it's more nuanced. Look at the data: real GDP grew at just 1.6 percent annualized in the first quarter. That's down from 2.9 percent a year ago. And the Atlanta Fed's GDPNow tracker for Q2 is pointing even lower, around 1.2 percent. Luna: And yet the job market is still pretty tight. Unemployment at 4.3 percent, 215,000 initial jobless claims last week — that's not recession territory. Lucas: No, it's not. But the trend is softening. JOLTS job openings fell again in March to 6.9 million, down from over 7 million. And wage growth is steady at 3.7 percent — enough to support spending, but not accelerating enough to add to inflation pressure. Luna: So the Fed sees a labor market that's still decent but no longer hot, and an economy that's slowing. That gives them room to cut. Lucas: Exactly. And the inflation story has two parts. Headline PCE is 2.4 percent, but core is 2.8 percent. The gap is energy — oil prices are up because of the Iran situation. Core services inflation, which the Fed watches most closely, is actually coming down, albeit slowly. Luna: So they can look through the energy spike and focus on the services disinflation. Lucas: Yes. And goods prices have been falling outright — used cars, furniture, electronics. That's deflationary. So the composition of inflation matters. The Fed's favorite measure, the trimmed mean PCE from the Dallas Fed, is actually at 2.5 percent. Luna: So the 'real' inflation is lower than the headline suggests. That supports a cut. Lucas: And markets are leaning into it. The S&P 500 is up 1.6 percent in the last five days, the Nasdaq up 2.4 percent. Small caps are really running — the Russell 2000 gained 3.3 percent in the same period. That's a classic 'Fed pivot' rally. Luna: But the bond market seems more cautious. The ten-year yield fell to 4.45 percent, but the two-year is still at 3.59 percent. The curve is steepening, but not dramatically. Lucas: The two-year is actually more interesting. It's down 23 basis points over the last week, which is a big move. That's the front end pricing in rate cuts. The ten-year is falling too, but less — because longer-term inflation expectations are sticky. The ten-year breakeven is flat at 2.39 percent. Luna: So the bond market is saying the Fed will cut, but inflation will stay above target for a while. Lucas: That's the consensus. And it creates an interesting tension. If the Fed cuts in June, it will be the first cut since the emergency easing during the banking mini-crisis in 2023. That would be a big signal. But it's risky — if inflation doesn't continue to moderate, they'd have to reverse course. Luna: Fed Governor Waller gave a speech last week that sounded like he was leaning toward a cut. He said the data is moving in the right direction, and that policy is already restrictive enough. Lucas: Waller has been a bellwether. He was one of the first to pivot from hawkish to dovish in 2023. If he's on board, the committee is probably close to a consensus. But Kashkari yesterday said inflation fight takes priority, and Goolsbee said energy inflation is persistent. So there's still debate. Luna: The market is pricing in a 90 percent chance of a quarter-point cut. That seems aggressive given the split. Lucas: It does. But remember, the Fed has been careful not to push back against market pricing. That's a tacit endorsement. If they thought the market was wrong, they'd have someone like Williams or Jefferson give a speech to recalibrate expectations. They haven't. Luna: True. So let's say they cut in June. What happens next? Lucas: I think that's the real question. A single cut is one thing. But if the economy continues to slow, they'll need to cut more. The market is pricing in two more cuts after June, by year-end. That would bring the fed funds rate to around 3 percent, from 3.62 percent now. Luna: That would be a significant easing cycle. And it would probably lift small caps even more, and maybe pressure the dollar. Lucas: The dollar has already weakened a bit. The trade-weighted index is down 1.5 percent this month. That helps exporters and multinationals, but it could also feed import inflation, which complicates the picture. Luna: So the Fed is walking a tightrope. Cut too fast, and inflation reaccelerates. Cut too slow, and the economy tips into recession. Lucas: That's the classic 'soft landing' challenge. But the data so far supports a cautious easing. The real economy is cooling, not collapsing. And the labor market is still creating jobs — just at a slower pace. Luna: One thing I notice is that real consumer spending is still positive, but slowing. The personal saving rate is down to 3.6 percent — that's low. Consumers are dipping into savings to maintain spending. Lucas: That's a risk. If savings run low, spending could drop sharply. And that would make the Fed's decision easier — they'd cut aggressively. But it could also mean a recession. Luna: It really comes down to the June jobs report. If we see payrolls below 150,000 and the unemployment rate ticking up, I think the cut is locked in. Lucas: Absolutely. The May jobs report comes out on Friday, June 5th, just a week before the FOMC meeting. That's a huge data point. If it's soft, the cut is basically certain. Luna: And if it's strong? If we get another 250,000 jobs? Lucas: Then the odds drop, but I don't think the cut is completely off the table. The Fed has signaled they want to ease, so they might still go ahead with a 'dovish cut' — doing it anyway but emphasizing that it's a recalibration, not the start of a cycle. Luna: That would be a bold move. They'd risk looking like they're caving to market pressure. Lucas: They might frame it as insurance. And honestly, given the lag in monetary policy, they need to look forward, not backward. Inflation is coming down, and the economy is slowing. Waiting too long would be a mistake. Luna: So you're in the cut camp, then? Lucas: I think they should cut, yes. And I think they will. But it's close. The data over the next two weeks will decide it. Luna: By the way, I've been meaning to say — I really appreciate that we can have this kind of conversation without any ad breaks or sponsored segments. It lets us dig into the data without interruption. Lucas: Yeah, that's intentional. We don't run ads on these shows. If you find value in that — and if our work helps you understand the economy a little better — you can support us at buy me a coffee dot com slash fexingo. That's F-E-X-I-N-G-O. Luna: It's a small gesture that keeps this independent. And it means we don't have to frame our analysis to please a sponsor. Lucas: Right. So back to the Fed: the key thing to watch is whether the tone from Fed speakers shifts in the next week. If we start hearing more dovish comments, the market will fully price in the cut. If they push back, we might see a pullback. Luna: We've got a speech from Chair Warsh on Tuesday at the Economic Club of New York. That's probably the most important event before the jobs report. Lucas: That's a big one. Warsh has been relatively quiet since taking over. His first FOMC meeting was in May, and they held rates steady. If he signals a willingness to cut, the market will take that as a green light. Luna: And if he sounds cautious? Lucas: Then we get volatility. But I think the overall direction is clear: the Fed is moving toward easing. The only question is the timing and pace. Luna: Alright, we'll be watching. Thanks for breaking that down. Lucas: Always a pleasure. We'll see you next time.