Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Core Inflation Hits 3.4 Percent What It Means for the Fed
Transcript
- Lucas: So we got the core inflation number for May this morning, and it came in at 3.4 percent year-over-year. That's the highest reading since October 2023. Luna: Right, and the market reaction was pretty immediate. The S&P 500 dropped another 1.9 percent on the week, and the NASDAQ is now down over 4 percent in five days. Lucas: Exactly. The headline CPI itself was 334, up from 332.4 in April. But the core number is what the Fed watches most closely, and it's clearly not coming down the way they hoped. Luna: And this is the Fed's preferred gauge, the core PCE price index, which also ticked up to 130.1 from 129.67. So it's not just one measure. Lucas: Right. The core PCE is running at about 2.9 percent annualized based on the latest data, but the year-over-year is still sticky. Meanwhile, the federal funds rate is at 3.63 percent, and the market is pricing in no cuts anytime soon. Luna: So what does the bond market see? The ten-year breakeven actually dropped to 2.18 percent from 2.21. That's a little counterintuitive, right? Inflation comes in hot and breakevens fall. Lucas: It is, until you realize that the bond market might be looking past this print and seeing a softening economy. The ten-year yield fell 1.6 percent on the week to 4.38 percent. The two-year is at 4.15. The curve is still deeply inverted. Luna: Yeah, the inversion is telling us something about recession expectations. But then you look at the job market and it's still strong on paper. Job openings jumped to 7.6 million in April from 6.9 million. Lucas: That's a big leap. And initial jobless claims fell to 215,000, which is very low historically. So the labor market is still generating demand for workers. But we also have factory layoffs spiking to levels not seen since 2008 and Covid. Luna: Right, so there's this divergence. Services side is still hiring, but goods-producing sectors are cutting hard. That's a classic late-cycle pattern. Lucas: Exactly. And it puts the Fed in a tough spot. If they cut rates now, they risk reigniting inflation. But if they hold, the factory weakness could spread. The Fed funds rate is at 3.63, which is still below the core inflation rate, so real rates are negative. Luna: Negative real rates are usually stimulative. So the Fed is technically still accommodative, even if they've paused. That's hard to square with the tightening they've done. Lucas: Well, and that's the whole debate. The nominal fed funds rate is 3.63, but core PCE is around 2.9, so the real rate is only about 0.7 percent. Historically, that's not very restrictive. The Fed might need to go higher to really cool demand. Luna: But then you have the ten-year breakeven dropping, which suggests the bond market thinks inflation will eventually come down. Maybe they believe the Fed's resolve? Lucas: Or they think a recession will do the work for them. The ten-year breakeven is a market-based expectation of average inflation over the next decade. If the economy slows, inflation pressure eases. That's the classic trade-off. Luna: And speaking of the economy slowing, real GDP growth was only 2.1 percent annualized in the first quarter, up from 0.5 at the end of last year. But that's still below trend. And nominal GDP is over 31.8 trillion. Lucas: Yeah, nominal GDP is growing at about 4.5 percent, which is fine, but real growth is modest. Productivity growth is doing some of the heavy lifting. But if inflation stays at 3.4, the Fed can't declare victory. Luna: So what's the path forward? The next FOMC meeting is in July. Do they hold again? Lucas: I think they have to hold. The unemployment rate is still at 4.3 percent, which is low. Average hourly earnings are up to $37.50. The labor market isn't screaming for stimulus. And the inflation data isn't giving them cover to cut. Luna: But the inversion in the yield curve is screaming. The ten-year minus two-year spread is still negative. That historically predicts recession within 12 to 18 months. Lucas: It does. But we've been inverted for over two years now and we haven't had a recession. So maybe this time is different? Or maybe the lag is longer. The bond market could be wrong. Luna: Or it could be right and we're just not there yet. The factory layoffs data from S&P seems to suggest that manufacturing is already in a contraction. That's a leading indicator. Lucas: It is. And if services start to crack too, then the Fed will have a different problem. But right now, the core inflation number is the headline. 3.4 percent. That's going to keep the pressure on the Fed to stay hawkish. Luna: So for investors, what's the takeaway? The NASDAQ is down 4.4 percent in five days, the Dow is actually up slightly. That tells you there's a rotation out of growth into value. Lucas: Yeah, the Russell 2000 small caps are up 0.9 percent on the week. Investors are betting that if the economy slows, small caps might be more insulated because they're more domestically focused. But it's a mixed signal. Luna: If walking through the economy with us has made something click, the way these episodes stay ad-free is through listener support. You can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it really helps keep the lights on. And we appreciate everyone who chips in. Luna: Absolutely. So back to the macro picture. If the Fed holds in July, what does that mean for the bond market? Lucas: If they hold, I think the curve stays inverted. The long end might rally if recession fears grow, pushing yields down further. That would steepen the curve, but from a deeply inverted starting point. Luna: So the ten-year could go below 4 percent? It's at 4.38 now. Lucas: It's possible, especially if the data turns softer. But if core inflation stays at 3.4 or higher, the long end might not rally much because inflation premium would keep yields elevated. That's the tug of war. Luna: Right. The breakeven dropping to 2.18 suggests the market is leaning toward disinflation. But the actual inflation data is sticky. So who's right? Lucas: That's the billion-dollar question. The market could be pricing in a recession that brings inflation down. Or it could be underestimating the persistence of inflation. We've seen that movie before. Luna: Look at the job openings jump. 7.6 million openings is a lot. That suggests employers still need workers, which could keep wage growth and inflation elevated. Lucas: Wage growth is around 4 percent annually, which is consistent with 3 percent inflation. So if the Fed wants 2 percent inflation, they probably need wage growth to cool to 3 or 3.5 percent. That's not happening yet. Luna: And with factory layoffs, maybe those workers shift to services, keeping the labor market tight. That's the reallocation story. Lucas: Exactly. The economy is rebalancing, not collapsing. That's the soft landing narrative. But a soft landing with inflation at 3.4 percent isn't really a soft landing. It's more like a bumpy plateau. Luna: So the Fed might have to accept that 3 percent inflation is the new normal unless they cause a recession. That's a tough choice. Lucas: It is. And the new Fed chairman, whoever that ends up being, will have to navigate that. The current committee seems divided. Some want to hold, some want to cut, some want to hike. Luna: Do you think they'll hike again? Lucas: I think it's unlikely unless inflation accelerates further. But if core PCE hits 3 percent year-over-year, they might feel compelled. Right now it's around 2.9, so close. Luna: And the effective fed funds rate is at 3.63. If they hike, where would they go? 3.75? 4 percent? Lucas: Probably 25 basis points to 3.88 or 4 percent. But that would be a shock to markets. The S&P is already down 1.9 percent in a week on just the inflation data. A hike would be worse. Luna: So the path of least resistance is to hold and wait for more data. That's what they've been doing. Lucas: Right, and the data is mixed enough to justify inaction. The economy is growing, jobs are there, but inflation is sticky and manufacturing is soft. It's a muddle-through scenario. Luna: For listeners trying to make sense of their portfolios, what's the one thing they should focus on? Lucas: Watch the ten-year breakeven and the weekly jobless claims. If breakevens keep falling while claims rise, that's a recession signal. If breakevens stabilize and claims stay low, we're in a holding pattern. Luna: Good advice. And maybe keep an eye on the factory layoff data. That's a canary. Lucas: Definitely. Alright, that's all for today. We'll be back tomorrow with more macro.