Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Core PCE at 3.4 Percent What It Means for Fed Policy
Transcript
- Lucas: So the core PCE price index hit 3.4 percent in May — that's the highest reading since October 2023. The Fed's preferred inflation gauge is moving in the wrong direction, and the market is trying to figure out what that means for rates. Luna: Right, and we got that number on Thursday. But here's the thing — the 10-year breakeven inflation rate actually dropped to 2.20 percent. That's down from 2.21 the day before. So the bond market isn't really panicking about this print. Lucas: That's the puzzle. Core PCE accelerates, but breakevens are falling. The bond market is essentially saying, 'We don't think this inflation spike is going to stick.' And that might be because a lot of the increase is coming from categories that tend to be volatile — like airfares, hotel rooms, that kind of thing. Luna: Yeah, services inflation ex-housing has been the sticky part. But the Fed has been focused on that. So what does a 3.4 percent core PCE do to the rate path? The fed funds rate is at 3.63 percent right now. Lucas: Well, the CME FedWatch tool before this print was pricing in about a 40 percent chance of a cut in September. I'd expect that probability to drop after this. But here's the twist — the labor market is softening. Job openings surged to 7.6 million in April, but hiring is still sluggish. And initial jobless claims just dropped to 215,000, which is low, but the trend has been edging up. Luna: So the Fed has this classic dilemma: inflation is sticky, but growth is slowing. Real GDP growth was only 2.1 percent annualized in Q1, which is okay, but not strong. And the unemployment rate is 4.3 percent, flat from the month before. Lucas: Exactly. And if you look at the yield curve, it's still inverted. The 2-year is at 4.13, the 10-year at 4.37. That inversion has been signaling recession risk for a while. But the economy keeps chugging along. So the question is: does the Fed have to choose between fighting inflation and supporting growth? Luna: It feels like they're stuck. They can't cut rates with core PCE at 3.4 percent. But if they keep rates high, they might break something in the labor market. We're already seeing factory layoffs spike — that was a big story a few weeks ago. Lucas: Right. And speaking of that tension — if walking through the economy with us has made something click, or if you just find these conversations useful, listener support is what keeps this show ad-free and independent. It's a small way to help us keep doing this. You can find us at buy me a coffee dot com slash fexingo. Luna: Yeah, we really appreciate it. And it helps us keep the focus on the data, not on selling ads. Lucas: So back to the inflation picture. The other thing I'm watching is average hourly earnings — they ticked up to $37.50 in May. That's a 2.4 percent year-over-year increase, which is actually below the inflation rate. So real wages are still negative for a lot of workers. Luna: That's a problem for consumer spending, which is the main driver of GDP. If people aren't seeing real wage gains, they might pull back. And we've seen some retail earnings that suggest consumers are getting more price-sensitive. Lucas: Right. So the Fed is in a tough spot. They want to see inflation come down, but they don't want to cause a recession. The dot plot from the last meeting showed two cuts penciled in for this year, but that was before this inflation print. I think the market is now pricing in maybe one cut, and not until December. Luna: And what about the geopolitical side? The headlines this week about the Strait of Hormuz and the Iran deal — that could affect oil prices, which feed into inflation. But so far, the market seems to be brushing it off. Lucas: Yeah, oil prices have been relatively stable. The breakeven rate dropping suggests that the market doesn't see a sustained energy shock. But it's a risk. If something disrupts supply, that could change the calculus quickly. Luna: So to sum up: core PCE at 3.4 percent, breakevens falling, labor market mixed, Fed stuck. What's the one thing you're watching for the next data point? Lucas: I'm watching the July jobs report. If we see another month of sluggish hiring and the unemployment rate ticks up to 4.4 or 4.5 percent, that might force the Fed's hand even with inflation elevated. Because the dual mandate includes maximum employment. They can't ignore a weakening labor market forever. Luna: Yeah, that's the key. The Fed has been saying they need to see more progress on inflation. But if the labor market cracks, they'll have to pivot. It's a delicate balance. Lucas: And that's the macro story of the second half of 2026 — can the Fed navigate a soft landing when inflation is proving stickier than expected? We'll find out.