Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / Why the Fed Is Tempted to Repeat Its 1970s Mistake
Transcript
- Lucas: So the Fed's own preferred inflation gauge just came in at 3.3 percent annual on core PCE for July. And you've got Governor Hammack saying, quote, now is the time to act on raising rates. That combination is starting to feel like a 1970s rerun, but maybe not for the reason everyone thinks. Luna: Because the common story is that the Fed was too slow in the seventies. But you're hinting that the mistake might be the opposite? Lucas: Exactly. The 1970s lesson is usually 'the Fed didn't raise enough, fast enough, and inflation got entrenched.' But look at what actually happened: they raised rates to twenty percent in 1981, and then they had to trigger a deep recession to break the back of inflation. The mistake wasn't just being late—it was overshooting once they finally moved. Luna: So the risk now is that the Fed, scarred by the seventies, overcorrects. With real GDP growth already at 1.5 percent annualized, they could tip us into recession. Lucas: Right. And the data we have this week shows why that's a live risk. The real economy is slowing—nonfarm payrolls actually dipped slightly from June to July, job openings fell to 7.36 million, which is the lowest in a while. The unemployment rate ticked down to 4.1, but that's because labor force participation is still muted. This is not an economy that needs the brakes slammed. Luna: But inflation is still sticky. Core CPI is up, core PCE is at 3.3. So what would you do if you were on the FOMC? Lucas: Well, that's the hundred billion dollar question. And to answer it, you have to think about what's driving inflation now versus in the seventies. Back then, you had wage-price spirals, oil shocks, and expectations that were firmly unanchored. Today, wages are growing at 3.6 percent hourly—that's not a spiral. Supply chains have healed. The inflation we're seeing is more concentrated in services and shelter. Luna: And that kind of inflation is less responsive to rate hikes, isn't it? Lucas: Precisely. Shelter inflation is driven by rents, which lag. Services inflation is driven by labor costs, which are sticky. Raising rates 50 basis points won't fix that overnight. It'll just slow down the economy that's already barely growing. The risk is that the Fed tightens into a slowdown and triggers a recession without actually killing the inflation—the worst of both worlds. Luna: That's the stagflation trap. So who's arguing for caution? Is there a dovish wing right now? Lucas: There's a growing group—including some former Fed officials—who say the Fed should hold steady and let the lagged effects of past hikes work through. They point to the fact that inflation expectations, like the ten-year breakeven at 2.32 percent, are still anchored. That's not the seventies, when expectations were spiraling. Hammack is leading the hawkish charge, but she's not unanimous. Luna: And then you have the Treasury Secretary making waves with his bond buyback plan. How does that complicate the Fed's job? Lucas: Huge. Bessent is essentially trying to manipulate the long end of the yield curve by tapping the Treasury General Account—potentially near a trillion dollars—to buy back outstanding bonds. That could push down long-term yields, which is stimulative. So you'd have the Fed hiking short-term rates while the Treasury is easing long-term conditions. That's a policy mix straight out of the seventies playbook, and it's not coherent. Luna: So the Fed is fighting one half of the curve, and the Treasury is fighting the other. That's a recipe for confusion. Lucas: Absolutely. And it's exactly the kind of thing that makes the Fed's credibility fragile. If the market sees the Fed hiking while the Treasury is pushing down yields, it might question whether the Fed is truly independent. And that's the real lesson from the seventies—not just the level of rates, but the credibility of the institution. Luna: Let's get concrete. What would an overcorrection look like this time? Lucas: The classic mistake would be to hike 75 basis points by year-end, even if the data shows growth stalling. You'd see the yield curve invert further, the dollar spike, and credit conditions tighten for small businesses—who are already feeling it. The Russell 2000 is down slightly this week while the S&P is up, which shows the pain is concentrated in the more rate-sensitive corners of the market. Luna: So what's the alternative? Wait it out? Lucas: There's a middle path. Hold rates where they are, communicate that you're watching the data, and let the natural disinflation from shelter and used cars continue. The 3.3 percent core PCE isn't great, but it's down from 3.6 percent earlier this year. If the Fed can tolerate a little pain on the inflation front for a couple of quarters, they might avoid the recession that would do far more damage. Luna: That's essentially betting that inflation will fade on its own, which is a gamble. Lucas: It is a gamble, but it's a calculated one. And the alternative is to bet that the economy can handle another shock. Look at the labor market: initial jobless claims are at 203,000, which is still low, but they're ticking up. If the Fed hikes too aggressively, those claims will jump, and then you'll have a recession on your hands—and you still won't have killed inflation because it's not demand-driven. Luna: So you're saying the Fed is in a no-win situation, but the lesser evil is doing nothing. Lucas: For now, yes. The Fed should be patient, not heroic. The 1970s lesson was that they were too reactive, lurching from one policy to another. Credibility comes from consistency, not from dramatic moves. If Hammack gets her way and they hike in September, they might get a brief rally in the dollar and a dip in gold, but it won't solve the underlying problem. And it could break the economy. Luna: Speaking of gold—it's hovering around $4,660 an ounce, which is near record territory. Is that the market telling us the Fed is going to fail? Lucas: Partly. Gold is trading as if it doesn't trust the Fed to control inflation. It's also a hedge against fiscal dominance—Bessent's debt management strategy, the trillion-dollar deficits, the possibility that the Fed becomes subservient to Treasury. That's a 1970s dynamic that we've been dancing around all episode. And gold is voting with its feet. Luna: So the real question is whether the Fed can maintain its independence while the Treasury is doing... that. Lucas: Exactly. And that's the thing I keep coming back to. The Fed's job is to set monetary policy for the whole economy, not to accommodate the Treasury's fiscal needs. If Bessent is actively trying to lower yields, the Fed has to decide whether to push back or go along. If they go along, they lose credibility. If they push back, they're in a standoff with the Treasury—which is almost as bad. Luna: It's like a game of chicken. And the market is starting to price in more risk of a policy error. Lucas: You can see it in the yield curve. It's not as inverted as it was, but it's still sending stress signals. And the equity market is split: the S&P is up this week, but the Russell is flat. That's a market that's not fully believing the soft-landing narrative. They're holding their breath. Luna: So if you're an investor, what do you do? Hide in gold? Buy short-term Treasuries? Lucas: I'm not giving investment advice, but I'll say this: the worst position to be in is one where you assume the Fed knows what it's doing. They don't. They're guessing, just like the rest of us. The safest play is to be humble, keep some dry powder, and be ready for either scenario—a Fed that blinks or a Fed that overdoes it. Luna: That sounds like a 1970s mindset, actually: prepare for the worst, hope for the best. Lucas: And that's the honest truth. If you're listening to this and you've been following along with our stagflation series, you probably have a better grasp of the dynamics than most market participants. It's a strange thing to say, but in an environment like this, understanding the history is a real edge. Luna: Speaking of edges, you know what's helped us keep making these episodes? The listeners who chip in a few bucks a month. It's not a big number, but it's what keeps this show ad-free and independent. If you've gotten something out of our stagflation deep dives, you can support us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's literally the only reason we can spend the time on these long-form analyses instead of chasing clicks. So, back to the Fed—if they do hike in September, what would be the first sign that it was a mistake? Luna: I'd watch jobless claims. If they jump above 250,000 within a month or two, that's a red flag. Lucas: Good call. And also watch the yield curve—if it un-inverts sharply, that often signals a recession is coming. The market is already pricing in a lot of uncertainty, so any move by the Fed will be amplified. But let's step back. The 1970s didn't end because the Fed got it right. It ended because Volcker was willing to accept a severe recession to restore credibility. The question is whether today's Fed has that same stomach, and whether the economy can survive it. Luna: And whether the Treasury will let them. Bessent's moves could undermine the Fed's tightening at every step. Lucas: Right. So the next few months are going to be a test of institutional will. I genuinely don't know if they'll pass. But I do know that watching it from the sidelines is going to be fascinating—and a little terrifying. Luna: I'll have the popcorn ready. But seriously, thanks for breaking it down, Lucas. This is one of those episodes that makes you feel smarter about the mess we're in. Lucas: That's the goal. And if you want to keep this kind of analysis coming, you know where to find us. Until next time, keep your eyes on the data—and maybe your gold coins close at hand.