Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Wholesale Price Shock And The Fed's Dilemma
Transcript
- Lucas: Look at the headline from Thursday morning: wholesale prices jumped six point three percent annually in September. That is the biggest gain we have seen since early twenty twenty-two. It completely flips the script on the narrative that inflation has been tamed. Luna: Six point three percent feels like a shocker when you are looking at the consumer side, where things seem relatively stable. Are producers passing these costs on, or are they just eating them? Lucas: They are trying to pass them on, but the transmission mechanism is broken. If you look at the Core PCE price index for August, it only moved up from one thirty point one three to one thirty point five. That is still sticky, but it is not exploding. The divergence between what businesses pay and what consumers pay is widening fast. Luna: So the pressure is upstream, but the downstream effect is lagging or being suppressed by weak demand? That sounds like a margin trap for companies. Lucas: Exactly. It is a margin trap. We know the U.S. budget deficit swelled to almost two trillion dollars for fiscal twenty twenty-six. That fiscal dominance keeps borrowing costs high, which pushes input costs up. But if retailers cannot raise prices because consumers are tapped out, those six point three percent costs come directly out of net income. Luna: That makes me think about the small business sector specifically. They don't have the cash buffers that big conglomerates do. Is this data going to force layoffs before the Fed even cuts rates? Lucas: It absolutely could. And this is why the market is twitchy. The S&P five hundred is down nearly two percent over the last five days. Investors are realizing that 'soft landing' might actually mean 'profit recession.' When profits fall, stock prices adjust. The Nasdaq is down four percent, which tells us tech and growth stocks are already pricing in slower earnings growth. Luna: Right, because tech relies on high multiples, and higher input costs without price hikes compress the denominator. But wait, the ten-year Treasury yield dropped almost three percent recently. Why are bond investors selling off yields if inflation is surging at the wholesale level? Lucas: Because they see the demand destruction coming first. Bond markets are forward-looking. They see that six point three percent cost push and assume that central banks will eventually have to break something to stop it. So they are betting on a sharper economic slowdown than the official data suggests. It is a flight to safety, not a vote of confidence in the current trajectory. Luna: So the Fed is stuck. If they hold rates, they risk letting inflation expectations embed. If they cut, they might fuel the very fire burning at the wholesale level. Where does Kevin Warsh fit into this chaos? Lucas: Warsh is interesting here because he has been arguing that the Fed is behind the curve. He thinks the market expects them to hold in October, but he believes they should be signaling much tighter policy for longer. His point is that the PPI data proves the disinflationary process isn't finished yet. Luna: But doesn't raising rates now hurt an economy that is already showing signs of cracking under debt servicing costs? The interest on reserve balances is sitting at three point nine zero percent. That is expensive money for everyone. Lucas: It is incredibly expensive. And remember, the effective federal funds rate is three point seven five percent. You are paying premium rates for capital right now. When you combine that with a twelve percent increase in the national deficit, you have a perfect storm. The government is borrowing more while private borrowers face stiff rates. It crowds out investment. Luna: Crowding out investment leads to lower productivity, which makes it harder to grow your way out of inflation. It is a vicious cycle. I am curious about the IMF warning that the Treasury dismissed yesterday. What was the substance of that warning? Lucas: The IMF flagged that our debt trajectory is 'messy' and unsustainable without structural reform. The Treasury dismissed it as bad forecasting, which is classic political deflection. But the numbers don't lie. A two trillion dollar deficit is not temporary anymore. It is structural. And that structural deficit keeps long-term yields elevated regardless of what the Fed does today. Luna: So the Fed's hands are tied by fiscal policy. They can control short-term rates, but they cannot control the long-term cost of capital if the government keeps flooding the market with debt. That seems like a fundamental flaw in the current framework. Lucas: It is a massive flaw. This is why I think the October meeting is critical. Everyone expects them to hold rates. But given this PPI data, silence might be interpreted as complacency. If they don't address the upside risk to inflation, markets could sell off harder. The VIX is likely creeping up. Luna: If they signal hawkishness, though, you get immediate pain in housing and auto sales. Who takes the hit first? Homebuilders or car dealerships? Lucas: Homebuilders. Mortgage rates are tethered to the ten-year yield. Even if the Fed holds, if the market sells off bonds because of inflation fears, mortgage rates go up. That kills affordability instantly. Auto sales are already sliding because credit card delinquencies are rising. Consumers are leveraged to the hilt. Luna: This feels less like a monetary problem and more like a solvency problem for the average household. How many people can keep refinancing their credit cards when rates are near four percent? Lucas: Very few. That is the danger zone. We are seeing delinquencies tick up across major banks. When that hits critical mass, consumption drops. And when consumption drops, the six point three percent wholesale inflation becomes irrelevant because nobody is buying the goods. Then we get deflationary pressure instead. It is a pendulum swing. Luna: A hard landing versus a stagflationary plateau. Both are ugly. I wonder if the Fed realizes they are managing expectations rather than reality at this point. They can't fix the deficit, and they can't force productivity growth overnight. Lucas: They know. But their mandate is narrow. They look at CPI and employment. They don't have a tool for fiscal sustainability. So they react. And right now, the reaction function is paralyzed. They see the jobs report as okay, so they hold. But the PPI screams that something is wrong upstream. Luna: It reminds me of the energy sector dynamics. Are supply constraints driving these wholesale prices, or is it purely financial? Lucas: It is a mix. Geopolitical tensions are keeping oil volatile, which feeds into transport costs. But it is also labor shortages in logistics. Trucking and warehousing costs are up. You cannot move goods cheaply when the workforce is tight and wages are rigid. Those labor costs embed into every product. Luna: So wage growth is feeding back into inflation via services. That is the classic second-round effect. Did the latest jobs report capture that service sector intensity? Lucas: It did, partially. The September jobs report showed solid hiring, but the wage growth was moderate. However, businesses are shifting costs to prices faster than they are raising base wages. It is a pricing power issue. They have enough leverage to raise prices despite flat wage growth. Luna: That gives me pause. If pricing power remains intact, the Fed never gets the relief it needs. They will have to keep rates restrictive for much longer than the market hopes. Lucas: Precisely. The market is pricing in cuts next year. I think we need to reset that expectation. With PPI at six point three percent, cuts are unlikely until we see consistent cooling in wholesale costs. That could take quarters. Luna: So investors are about to learn a painful lesson about patience. The era of easy liquidity might be paused indefinitely. Lucas: Before we dive deeper into what this means for your portfolio in November, I want to ask for your support. This show is entirely ad-free, and keeping it running requires resources. If walking through these complex economic shifts has made something click for you, consider supporting the network. You can find us at buy me a coffee dot com slash fexingo. Your contributions help us dig deeper into these topics for all of you. Luna: We really appreciate it. It allows us to stay independent and focus on the data rather than chasing clicks. Thanks for listening. Lucas: Let's circle back to the portfolio implications. If rates stay higher for longer, how should you position yourself? Cash is yielding close to four percent now. Is that the new safe haven? Luna: Cash is attractive, but it loses value to inflation if inflation stays at three percent. You need assets that grow faster than the general price level. That means equities with strong pricing power, not speculative growth stocks. Lucas: Right. Look at the defensive sectors. Utilities and healthcare are holding up better because they have regulated or inelastic demand. They can pass costs through more easily. Speculative tech is getting crushed because their valuations rely on distant future cash flows, which are worth less at higher discount rates. Luna: So quality over quantity. Companies with real assets and real margins. It feels like a return to value investing principles after years of momentum trading. Lucas: Exactly. The style rotation is happening in real time. The Russell twenty hundred is down two point six percent. Small caps are suffering under the weight of variable-rate debt. Large caps with fixed-rate debt are sleeping soundly. Luna: Debt maturity profiles matter more than ever. Check your own balance sheet. Are you exposed to refinancing risk in the next twelve months? Lucas: That is the key takeaway. Lock in rates if you can. Refinance high-cost debt. And stop expecting the Fed to save you from fiscal mismanagement. They won't. You have to navigate this environment yourself. Luna: It is a tough call, but recognizing the disconnect between wholesale and consumer prices is the first step to making smarter decisions. Lucas: Absolutely. The data is screaming that the job isn't done. The question is whether the Fed has the stomach to finish it, or if they will blink first.