Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How Core Inflation Is Sticking Despite a Flat Fed Rate
Transcript
- Lucas: So the Fed's rate has been sitting at 364 since February. And yet, the latest CPI reading — April data — came in at 332.4, up from 330.29 in March. That is not a cooldown, that is an acceleration. Luna: Right, and the core number is even more stubborn. Core CPI hit 335.4, up from 334.17. So the headline gets a little help from energy, but strip that out and prices are still climbing. Lucas: Exactly. Headline CPI gets some downward pressure from gasoline — the Iran situation has actually pushed oil prices down weirdly enough, because traders are pricing in a demand shock. But the core — services, shelter, insurance — that's where the stickiness lives. Luna: And the PCE data, which the Fed officially targets, is also creeping up. March PCE was 130.3, versus 129.48 the month before. Core PCE at 129.3 from 128.9. Not huge moves, but they're all in the wrong direction. Lucas: So the question is: if the Fed is holding at 364 — which is already restrictive by most estimates — why isn't inflation coming down faster? The old playbook says higher rates slow demand, which slows price increases. Luna: But the economy isn't really slowing in the traditional sense. Small caps are up more than 3% in the last five days. The Russell 2000 is at 2,869. That's not a recession signal. Lucas: No, it's not. And the consumer sentiment number that came out Friday — record low — that's interesting because it's driven by inflation expectations, not by actual spending. People are still spending. They're just angry about it. Luna: Angry spending. That's the economic theme of 2026. So what does the bond market make of all this? Lucas: The ten-year yield has actually come down a bit — it's at 4.56%, down about six basis points on the week. The thirty-year is at 5.06%, also down. That's a little counterintuitive if you think higher inflation should push long-term yields up. Luna: But the breakeven inflation rate on the ten-year is ticking up. It's at 2.40% now, up from 2.39% last week. So the market is pricing in more inflation over the next decade, even as nominal yields dip. Lucas: That's the key tension. Real yields are falling. The ten-year real yield — which is the nominal yield minus breakeven — is roughly 2.16%. That's down from where it was a month ago. So the bond market is saying: the Fed is tight enough that growth might slow, but inflation expectations are still sticky. Luna: Which brings us back to the neutral rate debate. How high is r-star? If the neutral rate is higher than the Fed thought, then 364 might not be as restrictive as it looks. Lucas: Right. Kevin Warsh has been hinting at that. He said at the April press conference that the economy might need a higher real rate than the old models suggested. But he also doesn't want to spook the market by raising rates again. Luna: Especially with consumer sentiment at a record low and a war dragging on. The political pressure to hold steady is enormous. Lucas: And that's the real bind. If the Fed raises rates, they risk tipping an already fragile consumer over the edge. If they cut rates, they risk letting inflation re-accelerate. So they sit at 364 and hope the data resolves itself. Luna: But the data isn't resolving itself. Core CPI has risen for three straight months now. The PCE is creeping up. The breakeven is rising. At what point does 'wait and see' become 'behind the curve'? Lucas: That's the million-dollar question. The bond vigilantes — remember them from earlier episodes? — they're still out there. The ten-year yield spiked to nearly 5% in January before Warsh took over. It's come down since, but if inflation stays hot, they could push it back up. Luna: And the inversion in the yield curve? The two-year is at 3.59%, the ten-year at 4.56%. That's still inverted, but less steeply than it was. The curve is normalizing, which historically has happened before recessions — but also before the end of tightening cycles. Lucas: Right. An inverted curve that starts to steepen can mean either a soft landing is coming, or a recession is. The market is trying to figure out which. The small-cap rally suggests risk-on, but the breakeven suggests inflation anxiety. It's a split personality. Luna: You know, we talk a lot about the macro data on this show, and it can get pretty dense. But one thing I really appreciate is that we don't have ads interrupting the flow. It's just us digging into the numbers. Lucas: Yeah, that's deliberate. We want this to be a resource you can actually follow without being sold something every five minutes. If you find it useful and want to support the no-ads approach, the link is buy me a coffee dot com slash fexingo. Luna: No pressure at all. But it does help keep the podcast independent and focused on what matters — the economics, not the commercial breaks. Lucas: Exactly. So back to that split personality in the market — one area where we're seeing real divergence is between large caps and small caps. The S&P 500 is up about 1% on the week, but small caps are up more than 3%. Luna: That's a pretty big gap. Typically small caps are more sensitive to domestic economic conditions and credit conditions. So if they're rallying, it suggests investors think the worst is over for the US economy. Lucas: Or it could be a catch-up trade. Large caps — especially the mega-cap tech names — have been on a tear for years. Small caps have lagged. So maybe it's just rotation into value. Luna: But the consumer sentiment data argues against a rosy outlook. Record low. People are really worried about inflation and the war. So is the small-cap rally just a bear market bounce? Lucas: Could be. Or it could be that the market is looking past the current inflation scare and pricing in a Fed that eventually cuts rates later this year. The futures market is still pricing in about 50 basis points of cuts by December. Luna: But if core CPI keeps rising, those cuts will get priced out fast. The Fed has consistently said they need to see 'greater confidence' that inflation is moving sustainably toward 2%. Right now, it's moving away. Lucas: So we're in a holding pattern. The data is muddy. The war adds a layer of unpredictability. And the bond market is sending mixed signals. The one thing that's clear is that the Fed's job isn't getting any easier. Luna: And the neutral rate — the rate that neither stimulates nor restricts the economy — might actually be higher than anyone thought. If that's true, then 364 might not be restrictive at all. It might be neutral, or even stimulative. Lucas: That's the scariest thought for the Fed. Because if the neutral rate has risen structurally, then they may need to raise rates further to actually cool the economy. And that would mean a lot more pain for consumers and businesses. Luna: We saw a research note from Goldman last week estimating r-star at around 1.5% in real terms. That would put the neutral nominal rate at about 3.9% given current inflation expectations. So 3.64% would be below that — actually accommodative. Lucas: If that's the case, then the Fed is inadvertently adding fuel to the fire. And that would explain why core inflation isn't coming down. The policy rate isn't high enough to restrain demand. Luna: But raising rates into a consumer sentiment record low and a war — that takes serious conviction. Warsh has the credibility from his bond market experience, but the political pressure is enormous. Lucas: And that's the story of this moment. The Fed is caught between a data-dependent framework and a reality where the data is contradictory. Inflation says tighten. Consumer sentiment says ease. The bond market says both at once. Luna: So what breaks the stalemate? Do we need a clearer signal from the economy, or do we need a shock — like a ceasefire or a spike in unemployment? Lucas: Probably a combination. If the war de-escalates, energy prices could fall further, which would help headline CPI. But core inflation is driven by services and shelter — those are stickier. That could take months or years to resolve. Luna: And if unemployment rises, the Fed would have a strong reason to cut rates, even if inflation is still above target. The dual mandate means they have to care about employment too. Lucas: Right now unemployment is still low — around 3.9% I think. But if the small-cap rally is real and those companies start hiring, that could keep the labor market tight and wages elevated, which feeds into services inflation. Luna: So the small-cap rally might actually be bad news for the Fed's inflation fight. A strong economy makes it harder to bring prices down. Lucas: Exactly. It's a catch-22. The economy needs to slow to bring inflation down, but if it slows too much, the Fed has to cut. The sweet spot is incredibly narrow, and we're nowhere near it. Luna: So for now, it's wait and see. But the clock is ticking. Every month that core inflation stays elevated, the risk of de-anchored expectations grows. And once that happens, it's much harder to get inflation back down. Lucas: That's the nightmare scenario. The 1970s playbook. And the bond market is already starting to price it in with that rising breakeven. The Fed has to act before expectations become unanchored, but they can't act without knowing where the neutral rate is. Luna: And they don't know. Nobody knows. We're all guessing. That's what makes this moment so fascinating and so dangerous. Lucas: We'll be watching the May CPI data next month. If that comes in hot too, the conversation changes. For now, it's a policy standoff between the Fed, the bond market, and the consumer. And right now, no one is blinking. Luna: Well, the consumer might blink first if prices keep rising. Sentiment is already at a record low. Actual spending could follow. Lucas: And if spending drops, the Fed gets its slowdown — but at a cost. That's the hard landing. We'll see which path we're on in the next few months.