Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Inflation That Keeps Marching Higher
Transcript
- Lucas: So we got the April PCE report on Thursday, and core inflation came in at an annual rate of 3.3 percent. That was exactly what economists expected, but exactly what the Fed does not want to see. Luna: Right, and the market barely flinched. The S&P 500 is up one point four percent over the last five days, the NASDAQ even more. It feels like traders are just shrugging off sticky inflation. Lucas: Yeah, look — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that honestly funds the whole operation. No ads, no sponsors, just people who find these macro conversations useful. Luna: And it makes a real difference. Keeps us independent, keeps the analysis straight. Lucas: So back to that PCE number. The headline was in line, but the composition is what matters. Energy inflation has been more persistent than the Fed expected — Goolsbee said that explicitly. And with the Iran war driving up gas prices, the average household is paying about $450 more per year on energy. Luna: That's a real squeeze. And it's not just at the pump — it feeds into everything. Shipping, manufacturing, even your grocery bill. Lucas: Exactly. And services inflation is still running hot. Shelter costs are moderating but very slowly. So you have this two-speed inflation story: goods prices are basically flat, but services are still rising at a pace that keeps core above 3 percent. Luna: And yet the ten-year breakeven inflation rate is sitting at 2.39 percent. That suggests bond markets think inflation will settle around the Fed's target over the longer term. Lucas: Right, but that's the market's expectation for average inflation over the next decade. The question is the path. The Fed's preferred measure has been stuck above 3 percent for months now. Kashkari said this week that the inflation fight takes priority, especially since the labor market is in decent shape. Luna: Decent shape — unemployment at 4.3 percent, job openings still high but trending down. It's not a hot labor market, but it's not cold either. Lucas: So the Fed is in this weird spot where they want to cut rates to support growth — real GDP growth annualized was only 1.6 percent in Q1 — but they can't because inflation is stuck. And the market seems to be pricing in rate cuts anyway. Luna: But is that a disconnect or is the market just looking past the near-term noise? Maybe they think energy inflation will fade once the Iran situation stabilizes. Lucas: Possible, but that's a big if. The breakeven rate hasn't moved much, which suggests the bond market is more skeptical about near-term disinflation. Equity markets tend to be more optimistic by nature. Luna: So who's right? The bond market has a better track record on inflation calls. Lucas: Historically, yes. But the yield curve is still inverted in some maturities. The two-year Treasury yield is at 3.59 percent, the ten-year at 4.45. That's a spread of about 86 basis points — still inverted, though less than before. Luna: And an inverted yield curve has historically been a recession signal. But the economy is still growing, albeit slowly. Lucas: Which brings us back to the 'soft landing' narrative. Can the Fed get inflation down without causing a recession? The data is mixed. Core PCE is sticky, but wage growth is moderating — average hourly earnings are up only about two and a half percent year over year. Luna: That's actually below inflation, so real wages are still falling for many workers. Lucas: And that's the double scar that CNBC mentioned — households are still scarred from the 2021-2022 inflation spike, and now they're facing another energy shock. Consumer sentiment hit a record low earlier this month, even though the economy isn't in recession. Luna: Yeah, there's a real paradox there. People feel terrible even when the data isn't that bad. But if inflation stays sticky, the Fed can't cut, and that could eventually tip the economy into something worse. Lucas: That's the risk. The market is pricing in rate cuts starting later this year, but if core PCE doesn't move down, the Fed will stay on hold. And inflation expectations could become unanchored if people start to doubt the Fed's commitment. Luna: What would it take for you to change your view? If we see a couple of months with core PCE below 3 percent? Lucas: Probably. But I think we need to see services inflation cool significantly, and that means shelter costs have to come down more. That's the biggest component. Also, energy inflation needs to reverse. If oil prices stay elevated due to the war, it's hard to see a quick path down. Luna: So for now, you're in the 'sticky inflation' camp. Lucas: I think the data supports it. The Fed's preferred gauge has been above 3 percent for over a year. The labor market is still tight enough to keep wage pressures from vanishing. And now you have a geopolitical shock adding to costs. It's not a recipe for rapid disinflation. Luna: And yet the market is up. So either the market is wrong, or it's seeing something we're not. Lucas: Could be that the market is looking past this year to 2027, expecting the Fed to eventually win. But that's a long horizon. In the meantime, real yields are still positive — the ten-year real yield is around 2 percent — so bonds are offering some protection. Luna: So for the average listener — what's the takeaway? Should they be worried about inflation or not? Lucas: I'd say don't ignore it. The market is pricing in a smooth landing, but the data suggests the runway is bumpy. If you're investing, maybe think about diversifying into assets that do well with persistent inflation — commodities, TIPS, things like that. Luna: And keep an eye on the breakeven rate. If it starts to move above 2.5 percent, that's a signal that the bond market is losing confidence. Lucas: Exactly. The breakeven has been remarkably stable around 2.4 percent, but if that changes, it'll be a big deal. For now, the Fed is stuck, the market is hopeful, and we're all watching the same data. Luna: Alright, next week we'll dig into the jobs report — nonfarm payrolls came in solid, but we might see some revisions. Lucas: Sounds good. That's it for today.