Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Can't Ignore the Strait of Hormuz Anymore
Transcript
- Lucas: So the Fed's preferred inflation gauge hit three point four percent in May — the highest since October 2023 — and the market barely flinched. The S&P 500 actually closed up on the day the data dropped. But there's something else happening right now that might matter more for the inflation path: the Strait of Hormuz. Luna: Because the shipping recovery is fragile, right? We had that U.S.-Iran deal a week ago, and then a vessel was attacked under the peace deal. The UN actually paused its evacuation plan. Lucas: Exactly. The headline is that shipping is rebounding in the Strait of Hormuz — that's the CNBC report from Friday. But 'fragile confidence' is the phrase they used. And for the Fed, this is suddenly a variable they can't wave away as transitory. Luna: Well, historically the Fed has treated energy price shocks as temporary — you look through them, focus on core. But core PCE is already at three point four percent. If headline inflation gets another leg up from oil, that feeds into expectations. Lucas: And that's the key mechanism. The ten-year breakeven inflation rate — that's the market's expectation for average inflation over the next decade — it's at two point two two percent as of yesterday. Up from two point two zero the day before. It's edging up, slowly. Luna: Two point two two is still inside the Fed's comfort zone if you believe in the two percent target. But the direction matters. If breakevens push above two point five, the Fed has a real communication problem. Lucas: Right. Because the Fed can't cut rates into a supply-driven inflation spike. If oil prices rise because of a shipping disruption — not because of strong demand — raising rates won't unstick a tanker. It just crushes the demand side of the economy. Luna: So the Fed is stuck. Core PCE is elevated, the jobs market is still adding jobs, and now you have a geopolitical risk that could push headline inflation higher. What's the play? Lucas: The play, based on the dot plot from the last FOMC meeting, is to hold steady. The effective federal funds rate is at three point six three percent, and the market sees cuts later this year. But if the Strait stays fragile, those cuts get pushed out. Luna: Let's talk about what a sustained disruption actually looks like. The Strait carries about twenty percent of the world's oil. Even a partial closure could add ten to fifteen dollars a barrel for how long? Lucas: Depends on the duration. But model-based estimates from the Dallas Fed suggest a one-month closure could add about one percentage point to headline CPI. That's significant when CPI is already at three thirty four on the index level — up from three thirty two point four one in April. Luna: And the Fed's own forecasts have missed repeatedly. We've done episodes on this — they admitted they can't forecast inflation well. So adding a geopolitical wildcard makes their projections even less reliable. Lucas: Which is why you're hearing more Fed officials talk about 'international spillovers' — we covered that a few episodes ago. They're signaling that the domestic data alone won't determine the rate path. Luna: And the data itself isn't giving them cover to cut. Core PCE at three point four, sticky services inflation still running hot. The Fed's favorite measure of services inflation ex-housing is still above four percent. Lucas: Right. So you've got domestic inflation that's too high to cut, and an external risk that could make it worse if you don't cut. That's the bind. And the only way out is if the Strait situation stabilizes. Luna: Which brings us to the UN pausing the evacuation plan. That tells you the security situation is not improving. The U.S.-Iran deal bought a window, but the window might be closing. Lucas: Look, if walking through the economy with us has made something click — especially on how these pieces fit together — and if today was worth a coffee to you, that's the link: buy me a coffee dot com slash fexingo. It's the smallest possible ask, and it keeps the show ad-free. Luna: Honestly, it makes a difference. We don't do sponsors, so listener support is what keeps us going. Lucas: So back to the Strait: the key date to watch is the next FOMC meeting, late July. By then we'll have another month of shipping data, another CPI print, and hopefully a clearer signal on whether the recovery is real or just a lull. Luna: And the market is pricing in about a fifty percent chance of a cut at that meeting. If the Strait data deteriorates, those odds could flip. Lucas: Exactly. Because the Fed's own tools are blunt here. They can't fix supply chains. They can't secure shipping lanes. All they can do is adjust demand, and if the shock is supply-driven, that's a bad trade-off. Luna: So what would it take for the Fed to cut despite a supply shock? If the economy starts to roll over? If jobless claims spike? Lucas: That's the other scenario. If the Strait disruption causes a confidence shock that hits business investment and hiring, then the Fed might cut to cushion the demand side. But that's a recession play, not a normalization play. Luna: And right now, the economy isn't showing recession signals. The S&P is at seven thousand four hundred forty, the Dow at fifty-two thousand. Markets are basically saying 'we trust the recovery'. Lucas: Markets also trust that the Fed will eventually cut. But if inflation expectations start to drift up because of energy prices, that trust erodes. And the Fed's credibility is really all they have in a supply-shock scenario. Luna: Because they can't control the price of oil. They can only control the price of money. Lucas: Right. And if the Strait stays volatile, the price of money might stay higher for longer than anyone expected back in January.