Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / How Tariffs Are Rewriting The Inflation Rulebook
Transcript
- Lucas: We usually talk about inflation as if it’s a monolithic force, like weather you just have to dress for. But there’s a new signal coming out of the New York Fed today that suggests we need to split the difference. They’re arguing that the recent uptick in prices for many everyday items isn’t coming from wage growth or stubborn services demand anymore. Luna: So you’re saying the engine has changed? I was looking at the core CPI number for August, it’s sitting at three hundred thirty seven point eight, which is still creeping up. Lucas: Exactly. And that number is why everyone is nervous. But the NY Fed breakdown points specifically to tariffs as the primary culprit for the goods-side pressure. It’s a structural shift. For years, we blamed logistics and labor shortages. Now, it’s policy. When you tax imports, that cost gets passed directly to the shelf, bypassing the usual negotiation between suppliers and retailers. Luna: That makes sense, but if it’s just tariffs, why are inflation fears rising so fast in the Fed survey? The one-year outlook hit its highest level since May twenty twenty three. Lucas: Because tariffs are sticky. A supply chain disruption clears up when the port opens or the factory restarts. A tariff doesn’t go away until the law changes. So consumers are feeling it immediately, and they’re adjusting their expectations upward because they know the government can’t easily reverse course. It creates a permanent ratchet effect on prices. Luna: And that complicates the Fed’s job immensely. They’ve been trying to cool demand, but if costs are being forced up by trade policy, cutting rates might not fix anything. Lucas: Right, and it might even make it worse. If the Fed cuts rates to help the housing market or small businesses, but tariffs keep pushing goods prices higher, you get stagflationary pressure. You’re seeing hints of this now. Real GDP growth slowed to two point two percent annualized, yet inflation remains elevated. That’s the paradox we’re living in. Luna: It’s interesting that the bond market seems to be ignoring some of that tension though. The ten year Treasury yield is down slightly to five point two four percent. Lucas: The bond market is always ahead of the narrative, but here it looks more like investors are betting on slower growth limiting the Fed’s ability to hike further, rather than ignoring inflation risks. The ten year breakeven inflation rate is flat at two point three six percent. That flatness is actually the scary part. It means the market thinks the Fed will tolerate higher prices for longer because they don’t have a good tool to fight tariff-driven inflation. Luna: Wait, do you think the Fed really doesn’t have a tool? Can’t they just raise rates enough to crush demand until prices fall? Lucas: Technically yes, but politically no. Look at the unemployment rate. It ticked up to four point two percent in September. Nonfarm payrolls added only two nine thousand jobs, which is weak compared to previous quarters. If the Fed pushes rates higher now, they risk triggering a recession to fight a price increase caused by foreign trade barriers. That’s a terrible trade-off for any central banker. Luna: So they’re stuck. Raise rates and kill jobs, or hold steady and let tariffs drive up your grocery bill. It feels like a lose-lose scenario for the average consumer. Lucas: It is a lose-lose, but we need to understand the nuance. Not all goods are affected equally. The NY Fed note highlights specific categories where import dependency is high. If you buy electronics or certain apparel, you’re feeling the tariff pain. If you’re mostly buying services like healthcare or education, you’re insulated. That creates a fragmented inflation experience across the country. Luna: Which means the headline CPI number might be misleading us about who is hurting. Core PCE is at one hundred thirty point five, up from one hundred thirty point one three. It’s slow, but it’s consistent. Lucas: Consistent is dangerous for the Fed because it anchors expectations. If people believe prices will stay higher, they negotiate harder for wages. And look at average hourly earnings. They rose to thirty seven point eight dollars. That wage growth is healthy for workers, but it feeds back into services inflation, keeping the whole system hot. Luna: So we have tariff-driven goods inflation and wage-driven services inflation. Two engines running at the same time. No wonder the VIX is hovering and markets are jittery. Lucas: Precisely. And this brings us to a broader question about global trade. We saw headlines about India’s central bank hiking rates due to similar inflation risks. It’s happening everywhere. Trade policy is becoming the dominant macro factor, displacing monetary policy as the main driver of price stability. Luna: It’s wild to think that a decision made in a legislature in Washington or Delhi has more immediate impact on your wallet than a vote by the FOMC. Lucas: That’s the reality of twenty twenty six. Fiscal and trade policy are now the primary shapers of the business cycle. Monetary policy is just reacting. The Fed Funds rate is at three point seventy five percent, but it’s essentially holding the line while tariffs do the heavy lifting on inflation. Luna: I’m going to pause us here for a quick moment. Walking through the complexities of tariff-driven inflation and fiscal dominance with us has likely highlighted why independent, clear economic analysis matters. We deliberately run no ads on these shows because we want our focus entirely on the data, not on selling you something. If you find value in this clarity and want to support that choice, the link is buy me a coffee dot com slash fexingo. Thanks for helping us keep this network ad-free. Lucas: Back to the data. The other piece of this puzzle is the job openings report. JOLTS showed job openings dropping to seven thousand thirty nine thousand. That’s a significant cooling. Luna: Yeah, and initial jobless claims fell slightly to one hundred ninety seven thousand. So employment is still relatively tight, but the demand for new hires is slowing down. Lucas: That slowdown is crucial. It tells us the economy is softening, but not collapsing. The labor market is losing momentum, which should theoretically reduce wage pressure. But if tariffs keep pushing up goods prices, real wages could stagnate even if nominal wages rise. Workers earn more dollars, but those dollars buy less imported stuff. Luna: That’s a real erosion of purchasing power. It’s not just about whether you have a job, it’s about what that paycheck actually covers when the baseline cost of living is set by trade wars. Lucas: Exactly. And this dynamic is visible in the small cap index. The Russell twenty hundred dropped one point five percent over the last five days. Small companies are more exposed to domestic supply chains and local labor costs, but they also face higher borrowing costs relative to large caps. Luna: While the S&P five hundred is up half a percent. The divergence is widening. Large caps are benefiting from pricing power, while small caps are getting squeezed from both sides. Lucas: Pricing power is the key phrase. Companies that can pass tariff costs onto consumers without losing volume are surviving. Those that can’t are seeing margins collapse. It’s a consolidation event disguised as inflation data. Luna: So the winners and losers aren’t just determined by efficiency anymore, but by their ability to navigate trade policy. That’s a huge shift in corporate strategy. Lucas: It is. And it forces corporations to rethink where they source materials. We’re seeing a lot of chatter about reshoring, but that takes time. In the short term, the tariff wall stays up, and prices stay high. The IMF chief recently talked about AI being both a hope and a hazard here. Could AI help offset these costs? Luna: Potentially. If AI improves productivity enough, it could lower the unit cost of production, effectively subsidizing the tariff burden. But that’s a long-term play. We’re dealing with immediate price spikes right now. Lucas: Immediate is what matters for the Fed. And the Fed is watching closely. With the interest on reserve balances at three point nine zero percent, banks are earning plenty to stay liquid. They aren’t forcing a credit crunch. The constraint isn’t liquidity, it’s confidence. Luna: Confidence in the price level. If people don’t trust that prices will stabilize, they act defensively. Saving more, spending less. Which slows growth further. Lucas: Which loops us back to that two point two percent GDP growth. It’s sluggish, but positive. The danger is if the tariff shock combines with a sudden drop in consumer sentiment to push us into negative territory. We haven’t seen that yet, but the components are aligning. Luna: It feels like we’re standing on a fault line. One misstep in trade policy or one unexpected dip in hiring could tip the scale. Lucas: That’s why the NY Fed’s distinction is so important. By identifying tariffs as the root cause, they’re giving policymakers a clearer target. Instead of fighting a ghost of demand-pull inflation, they can focus on supply-side relief or targeted fiscal measures. Luna: Or they can just wait it out. Sometimes the best move is to do nothing and let the political cycle resolve the trade tension. Lucas: Waiting is expensive though. Every month of elevated inflation erodes household wealth. The question is whether the Fed can afford to wait, or if they’ll be forced to act preemptively. Luna: Given the unemployment rate is already rising, I doubt they’ll act aggressively. They’ll probably try to guide expectations instead. Lucas: Guidance is all they have left. And in a world where tariffs dictate prices, guidance is a fragile tool. We’ll see how this plays out over the next quarter. Luna: One thing to watch: if the ten year breakeven starts to climb above two point five percent, it’ll mean the market has lost faith in that guidance. Lucas: Spot on. Until then, we’re in a holding pattern. High prices, moderate growth, and a Fed that’s watching the trade reports more than the payroll numbers. Luna: A new normal, then. Where trade policy is the silent driver of the macro economy. Lucas: Silent until it isn’t. Let’s keep an eye on those import prices for next month.