Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What the Fed Is Learning from the Iran War Energy Spike
Transcript
- Lucas: So the average U.S. household is now paying about $450 more per year on gas and energy because of the Iran conflict. That number is from CNBC late last week, and it's one of those figures that makes you stop and ask: what does the Fed actually do with that? Luna: Right, because a supply shock from a war isn't something the Fed can just raise rates away. Lucas: Exactly. And that's the tension we're seeing play out in real time. Core CPI hit an annual rate of 3.3 percent in April — that's the Fed's preferred gauge, the PCE price index, not the headline CPI. But the energy component is what's sticking out. Chicago Fed President Austan Goolsbee told CNBC last Thursday that energy inflation has been 'more persistent than expected.' Luna: I saw that. And Minneapolis Fed President Kashkari said the same week that the inflation fight takes priority because the labor market is 'in decent shape.' Lucas: So you've got two Fed officials essentially saying: we know this is a supply-driven spike, but we can't just ignore it. Because if households start expecting higher energy costs to persist, that feeds into wage demands, which then becomes a self-fulfilling cycle. Luna: But the 10-year breakeven inflation rate — that market-based expectation measure — is only at 2.40 percent. That's not signaling panic. Lucas: It's not. And that's the interesting part. The breakeven has actually ticked up from 2.38 percent at the end of May, but it's still well within the range the Fed would consider anchored. So the bond market is basically saying: we trust that the Fed won't let this become a 1970s-style wage-price spiral. Luna: But that trust is fragile, right? Because if the war drags on, or if there's another supply disruption, those expectations could unanchor. Lucas: That's the risk. And it's why you're hearing a hawkish tone from the Fed even as the effective federal funds rate has barely budged — it's been at 3.63 percent since the beginning of May, down just one basis point from April. The Fed is holding steady, but the rhetoric is saying: we're ready to move if we have to. Luna: So what does 'if we have to' look like? Are we talking about a rate hike in a supply-shock environment where higher rates might not even help? Lucas: Yeah, that's the classic central banker's dilemma. If you raise rates to tamp down demand, you might cool the economy and reduce pressure on non-energy prices. But you can't drill more oil with interest rates. So the effect on gas prices is indirect at best. What the Fed is really trying to do is prevent the shock from spreading into core services — things like rent, healthcare, wages. Luna: And the PCE data from April shows core services inflation is still running above 4 percent, isn't it? Lucas: It is. The core PCE price index itself hit 130.9 in April, up from 130.38 in March. That's a month-over-month increase of about 0.4 percent, which annualizes to nearly 5 percent. So the underlying trend is still hot, even if the headline number is around 3.3 percent year-over-year. Luna: So the Fed is stuck between a supply shock that it can't fix and a core inflation that it's supposed to fix. Lucas: Exactly. And that's why the bond market is so fixated on the 10-year yield, which is at 4.47 percent today — down about 4 basis points over the last five days. That's actually a bit of a decline, which suggests some investors think the Fed will be able to hold the line without hiking. Luna: But the 2-year yield is at 3.62 percent, which is basically right at the effective fed funds rate. So the front end is saying: no rate cuts anytime soon. Lucas: Right. The 2-year is essentially the market's expectation for where the fed funds rate will average over the next couple of years. And at 3.62 percent, it's basically flat with the current 3.63 percent effective rate. So the market is pricing in no meaningful cuts, and maybe even a small chance of a hike. Luna: And the long end of the curve, the 30-year bond yield at 4.99 percent, is just a hair below 5 percent. That's the term premium — investors demanding compensation for inflation uncertainty over decades. Lucas: Which brings us back to the war. The Iran conflict has injected a level of uncertainty that makes it very hard for the Fed to communicate a clear forward path. Normally, you'd look at the labor market — and it's still tight, but not overheating. You'd look at consumer spending — it's slowing but not collapsing. And then you have this exogenous shock that hits energy prices directly. Luna: And the double scar we've seen in some consumer surveys — people still scarred from the 2021-2022 inflation spike, and now this new shock — makes the psychology harder to manage. Lucas: Yeah, that phrase 'double scar' really stuck with me from the CNBC piece. Consumers are already wary, and then they see gas prices jump again. Even if the actual inflation rate is lower than it was in 2022, the experience of paying more at the pump is visceral. And that can drive behavior — they might pull back on spending, which in turn could slow the economy. Luna: So the Fed is essentially trying to calibrate a response to a shock that is both inflationary and potentially recessionary at the same time. That's the worst of both worlds. Lucas: It really is. And it's why you hear Fed officials like Goolsbee and Kashkari emphasizing that they're 'data dependent' — because they genuinely don't know how this plays out. If the war de-escalates and energy prices fall, they can stay on hold. If it escalates and supply chains get disrupted further, they may have to tighten into a weakening economy. Luna: Which is precisely why the financial press is watching every single energy inventory report and every geopolitical headline. Lucas: And every FOMC speech. This week we've got a few more Fed speakers scheduled, and the market will parse every word for any hint of a bias shift. Because right now, the consensus is 'wait and see,' but that consensus could crack. Luna: Before we wrap, Lucas — and this is a bit meta — but conversations like this are exactly why I love doing this show. It's not just reading off a data sheet; it's actually trying to understand the trade-offs. Lucas: I feel the same way. And you know, a lot of listeners have told us that these deep dives help them make sense of the noise. If that's you, and you've gotten some value out of the episodes — especially since we keep the show ad-free — there's a simple way to support it. You can go to buy me a coffee dot com slash fexingo. Even a couple of bucks a month genuinely helps keep the lights on. Luna: Yeah, it really does. No pressure at all — but if our breakdowns have made something click, that's the place. Lucas: Alright, back to the data. One number I want to circle back to: the 10-year breakeven at 2.40 percent. That's actually up from 2.38 percent on May 29th. So while the market isn't panicking, it is slowly repricing inflation expectations higher. If that trend continues, it puts more pressure on the Fed to act. Luna: So the key metric to watch in the coming weeks is not just CPI or PCE, but the breakeven rate — because that's where the market's inflation psychology lives. Lucas: Exactly. And if the breakeven pushes above 2.5 percent, that's when the Fed will start to get really uncomfortable. Because anchored expectations are the single best tool they have. Lose that, and you're fighting a much harder war. Luna: And a war they'd rather not fight. Lucas: Right. So for now, it's all about the energy data, the geopolitical headlines, and the breakeven rates. That's the triad that will determine whether the Fed stays on hold or has to move. We'll be watching.