Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How the Fed Decodes Conflicting Signals from CPI and PCE
Transcript
- Lucas: So here's the puzzle of July 2026, Luna. The latest CPI reading, released last month, shows headline inflation fell for the third straight month to 332.6 — that's down from 333.98. Yet the Fed's preferred measure, core PCE, actually ticked up to 130.1 from 129.67. That is not what the committee wants to see. Luna: Right, because the Fed has been pounding the table that PCE is their true north. So a divergence like this — CPI down, PCE up — must be giving them heartburn. Lucas: Exactly. And the timing matters. We're heading into the August lull — no FOMC meeting this month, but the Jackson Hole symposium is coming. Chair Warsh, who took over in February, has already signaled that the committee is watching for 'sustained progress' on inflation. Those were his words in the July press conference. Luna: Kevin Warsh, right. Fed watchers have been parsing every phrase he uses. He's got a very different style from Powell — more academic, more deliberate. Lucas: Exactly. And this data divergence is the kind of thing that tests his framework. On one hand, headline CPI falling suggests broader disinflation is on track. On the other, core PCE rising — even by a fraction — suggests that the stickiest components, like housing and services, aren't cooling as fast. Luna: Let's quantify that. Core PCE went from 129.67 to 130.1 — that's about a 0.33% increase. That's not massive, but it's a reversal after several months of declines. Lucas: Right. And that's enough to make the committee pause. Remember, the effective fed funds rate is sitting at 3.63%, and the interest on reserve balances is 3.65%. That spread is razor thin — it signals that the Fed has tight control over short-term rates. They're not in a panic. Luna: But the 10-year breakeven rate has slipped to 2.26%, down from 2.28%. So inflation expectations are actually dropping. That's a counter-signal. Lucas: It is. And it's the kind of nuance that the Fed will chew on. They want to see inflation expectations anchored around 2%. The breakeven is a little above that, but heading in the right direction. So the PCE uptick might be noise — maybe seasonal adjustments, maybe energy costs passed through with a lag. Luna: Or it could be import prices. Headlines recently showed a surprise gain in import costs from China, hitting the highest since 2008. That's a tariff effect, and it feeds directly into goods PCE. Lucas: That's the key point. The new global tariffs that the administration rolled out last week — with forced labor justifications — are creating uncertainty in supply chains. Goods prices could start to climb again. That would show up in core PCE before CPI because PCE gives more weight to goods that are imported. Luna: So the Fed is facing a two-sided risk: services inflation is sticky, and goods deflation might reverse. That's a recipe for holding rates steady for longer. Lucas: I think that's the consensus. The futures market still prices in about a 40% chance of a cut by year-end, but after this PCE number, those odds might shrink. Warsh's comments this week — he used phrases like 'data dependent' and 'patient' — that's code for 'we're not in a hurry.' Luna: But what about the consumer? We saw that the World Cup gave bars and restaurants a boost, but consumer stress signals are flashing. If spending slows, that could pull inflation down without the Fed needing to act. Lucas: That's the soft landing scenario. The Fed wants to see demand cool enough to bring down services inflation, but not so much that unemployment jumps. So far, the labor market has held up. No major layoffs. But the tariff news could change that if companies start passing on costs. Luna: Let's put ourselves in Warsh's shoes. If I'm seeing CPI fall, core PCE rise, breakevens dropping, and tariff uncertainty spiking, I'd want to hold and wait for more data. The August lull gives them time to think. Lucas: Yeah, that's exactly what they'll do. The next FOMC meeting is in September. By then they'll have two more CPI prints and one more PCE. That's enough to confirm whether this divergence is real or a blip. Luna: What about the balance sheet? The runoff continues at full speed, but reserves are still ample. The Fed is shrinking its holdings by about $60 billion a month — that's a tightening force on its own. Lucas: And it's hitting bank reserves. We saw that in the last quarterly report — reserve balances have dropped by about $200 billion this year. That could put upward pressure on short-term rates if it goes too far. But the Fed has the standing repo facility as a backstop. Luna: So the overall picture is a Fed that is comfortable with the current rate level but watching for any sign that inflation is reaccelerating. And the PCE uptick is exactly that kind of sign. Lucas: Right. And we should emphasize that the Fed's dual mandate — maximum employment and price stability — gives them cover to hold if inflation is still above target. Core PCE at 130.1 is about 2.5% annualized, still above the 2% goal. So no cut until that's sustainably lower. Luna: And yet, the market has been pricing in cuts. That disconnect between the Fed's dots and market expectations is a classic tension. Warsh has been pretty good at managing expectations — he doesn't surprise. Lucas: That's true. His three key phrases — 'data dependent,' 'patient,' and 'prepared to adjust if needed' — give him maximum flexibility. He's not boxed into a timeline. Luna: Alright, so wrapping up: CPI is down, core PCE is up, breakevens are steady, tariffs are coming. The Fed holds steady at 3.63% through September, maybe through year-end. That's the base case. Lucas: I'd agree. And if we see that core PCE reverses back down in the next two prints, then the conversation changes. But for now, the bar for a cut is high. Luna: And we should note that the episode you're listening to is ad-free, which is intentional. If you get value from walking through the economy with us, consider supporting that independence. Lucas: Yeah, there's no sponsor here — it's just us doing the work. A listener-supported model keeps it that way. The link is buy me a coffee dot com slash fexingo, if that's your thing. Luna: And we appreciate the ones who already do. Now, back to the data: what about the upcoming GDP advance estimate for Q3? That could shift the narrative. Lucas: Good point. The Atlanta Fed's GDPNow tracker is running around 2.3% for Q3. That's solid, not hot. If that comes in weaker, combined with inflation cooling, then the doves might have more to say. But for now, the hawks have the upper hand. Luna: Ultimately, it comes down to whether the PCE bump is a head-fake or a trend. And the only way to know is to wait. Lucas: That's the Fed's job in a nutshell: wait and see, while communicating clearly. And on that note, we'll wrap it up. Thanks for listening to The Federal Reserve Podcast.