Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching Real Rates More Than Headline CPI
Transcript
- Lucas: If you've been following the economic data lately, you know headline CPI has been creeping up — the May reading came in at 334.0, up from 332.41 the month prior. That's about a 2 percent annualized increase, but the market's not really reacting to that number the way it used to. Luna: Right, because the Fed has been signaling for months that they're looking through the noise. But what are they actually focused on? Lucas: The short answer is real rates. Not the nominal fed funds rate or the ten-year yield, but what you get after you subtract inflation. And right now, the ten-year breakeven inflation rate — that's the market's expectation for average inflation over the next decade — is sitting at 2.25 percent, basically flat for weeks. Meanwhile the ten-year nominal yield is 4.53 percent. Do the math and the real yield is roughly 2.3 percent. Luna: So the real yield is positive and actually pretty high by post-financial-crisis standards. That's the restrictive part. Lucas: Exactly. And that's what Chair Powell keeps circling back to in his press conferences — he'll say policy is restrictive, and then he points to the real funds rate or real longer-term rates. The nominal fed funds rate is 3.63 percent, but the core PCE deflator is running at about 2.6 percent year-over-year. So the real funds rate is barely above 1 percent. That doesn't sound that tight. But if you look at the ten-year real yield, it's more than double that, and that's what actually matters for mortgage rates, corporate borrowing, and the broader economy. Luna: Because the ten-year is the benchmark for most private borrowing. So the Fed might be saying one thing with the fed funds rate, but the bond market is doing the heavy lifting. Lucas: Right. And this creates a kind of tension. The FOMC meets later this month — July 28th and 29th — and the implied probability of a rate cut is basically zero. But the market is pricing in a cut by September. The reason the Fed can afford to wait is precisely because real rates are already doing some of the work. If they cut prematurely and inflation reaccelerates, they risk unanchoring breakevens. But if they hold too long and the economy softens further — remember, June payrolls came in at just 57,000 — then the real rate becomes accidentally tighter as inflation falls. Luna: Let's talk about that payroll number for a second. 57,000 jobs in June, unemployment ticked up to 4.2 percent. The labor force participation rate also dropped to its lowest outside of the pandemic. That's a weakening labor market, but inflation is still sticky. So the real rate lens actually helps explain why the Fed isn't panicking. Lucas: Exactly. Because if you look at the real ten-year yield, it's not at some extreme level. Back in late 2023, the ten-year real yield touched 2.5 percent — that was the peak of the hiking cycle. Now it's around 2.3 percent. So it's come down a bit, but it's still above what many economists estimate as the neutral real rate, which is probably around 0.5 to 1 percent. So the message is: rates are restrictive, but not catastrophically so. The Fed can afford to be patient. Luna: Patience is the word. But there's a historical parallel here, isn't there? Janet Yellen in 2015 — she was hesitant to hike because inflation was below target, but she also didn't want to wait too long. Lucas: Right, and the playbook then was to slowly normalize rates while keeping an eye on real activity. But today's situation is inverted in a way: inflation is above target, not below. So the Fed is trying to avoid the mistake of the 1970s — where they eased too early — but also the mistake of 2018, where they hiked too far and then had to reverse. The real rate framework gives them a way to calibrate that. Luna: And speaking of calibration, I know this show is ad-free and listener-supported, and that's something we're proud of. If you find these kinds of frameworks useful — real rates, historical parallels — the best way to keep us going is to throw a few dollars our way. You can do that at buy me a coffee dot com slash fexingo. We don't have ads, so listener support is what keeps the lights on. Lucas: Yeah, it's a small gesture that makes a big difference. And it helps us keep doing deep dives like this one. So thank you to everyone who's contributed. Luna: Absolutely. Alright, so back to the real rate picture — one thing I want to dig into is how the Fed actually uses TIPS yields to gauge market expectations. The ten-year TIPS yield is the real yield, right? That's the market's view. Lucas: Yes. The TIPS market is probably the cleanest signal. The ten-year TIPS yield is about 2.28 percent as of this week. That's the real yield the market demands for locking up money for ten years after accounting for inflation. Compare that to the ten-year nominal yield of 4.53, and the difference is the breakeven — 2.25. So the market is pricing inflation at 2.25 percent over the next decade, which is right around the Fed's target. That's actually comforting for the Fed. It means long-term inflation expectations are anchored. Luna: But if the real yield stays this high while the economy slows, that could become a problem. We saw that in the early 2000s and again in 2008 — real yields were high before recessions. Lucas: Right, and that's the risk. The Fed's dual mandate is maximum employment and price stability. Right now price stability is close enough — core PCE is at 2.6 percent, trending down. But employment is showing cracks. The participation rate falling to levels not seen since the 1970s outside of COVID — that's a structural issue that monetary policy can't fix, but it does affect the output gap. If the economy is operating below potential because people are dropping out, then the real rate might actually be too high. Luna: So what does the Fed look at in the next few weeks? The July FOMC is probably a hold. But what data would change their mind? Lucas: I think they're watching two things. First, the monthly CPI and PCE prints — if core inflation starts to reaccelerate, that would argue against cutting even if the economy weakens. Second, the labor market — if payrolls stay below 100,000 and unemployment rises above 4.5 percent, then the real rate becomes a problem. But for now, the real yield is telling them to stay put. Luna: And the bond market seems to agree. The yield curve is still inverted, but less so. The two-year is at 3.69, the ten-year at 4.53 — that's a steepening, but still inverted by historical standards. That's usually a recession signal. Lucas: It is. But the inversion has been in place for over two years without a recession, so the signal is noisy. The real rate story gives a cleaner read: the Fed wants to see real yields come down as inflation falls, but not so fast that financial conditions ease prematurely. That's the balancing act. Luna: And that's why they're talking about real rates more in speeches. I noticed Governor Waller mentioned it in his last talk — he said the real fed funds rate is 'modestly restrictive' but the ten-year real yield is 'more clearly restrictive.' That's a direct quote. Lucas: Exactly. And that language matters. When a Fed official says 'the ten-year real yield is restrictive,' they're essentially saying the bond market is doing part of their job for them. So they can afford to wait. That's the key takeaway for listeners: don't obsess over fed funds rate alone. Watch the real ten-year yield. If it stays above 2 percent, the Fed is in no hurry to cut. Luna: And if it drops below 2 percent? Then we might see them move. But for now, it's a waiting game. Lucas: Absolutely. And we'll keep watching the data. Next week we get June CPI, and if that shows a surprise to the upside, real yields could rise further. That would tighten conditions without the Fed doing anything. It's a fascinating dynamic. Luna: It really is. Thanks for breaking it down, Lucas. Lucas: Thanks, Luna. And thanks to our listeners for sticking with us. We'll be back next week with more.