Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Fed's Two Inflation Problem That Markets Are Missing
Transcript
- Lucas: So the April PCE data landed this morning, and core inflation came in at 3.3 percent annualized — right on consensus. But the market reaction was interesting. The ten-year yield actually dropped two basis points after the release. That's not the response you'd expect if investors were worried about a reacceleration. Luna: Right, because headline PCE was also up 0.3 percent month-over-month, which is still above the Fed's target. So why did bonds rally? Lucas: That's the puzzle. I think the answer is that markets are starting to distinguish between two different inflation problems. Goods inflation has cooled significantly — core goods prices actually fell again in April. But services inflation remains sticky, especially in housing and medical care. So the bond market is betting that the Fed can eventually get the services side under control without having to crush the economy. Luna: But we heard from Fed's Goolsbee today on CNBC, and he specifically called out energy inflation as more persistent than expected. That's not services, that's a supply-driven cost that the Fed can't really fix with rate hikes. Lucas: Exactly. And that's the tension. Energy inflation is being driven by geopolitical factors — the Iran situation, supply chain disruptions. That's not demand-pull inflation. So the Fed is caught between a core services inflation that is slowly responding to tighter policy, and an energy component that is totally outside its control. The breakeven inflation rate — the market's expectation for inflation over the next decade — is at 2.39 percent today. That's down slightly from yesterday. So the bond market is basically saying: we see the disinflation trend continuing, even if the monthly prints are noisy. Luna: And yet the Fed's own preferred gauge, core PCE, is still running at 3.3 percent. That's a full percentage point above the target. So how do you reconcile a market that's pricing in rate cuts with a Fed that's still saying rates need to stay higher for longer? Lucas: I think the market is looking ahead to the labor market data. We got JOLTS job openings for March today — 6.866 million, down from 6.922 million. That's a gradual cooling. And initial jobless claims bumped up to 215,000 last week. The labor market is softening, but not collapsing. That's the sweet spot for the Fed: enough slack to take pressure off wages, but not so much that it triggers a recession. The market is betting that the Fed will be able to cut rates once or twice later this year, starting in September. Luna: But Kashkari said today that the inflation fight takes priority, and the labor market is 'in decent shape.' So he's not sounding dovish at all. Lucas: No, and that's the official line. But look at the data beneath the surface. Real GDP growth for the first quarter came in at an annualized 1.6 percent — that's up from 0.5 percent in the prior quarter, but it's still below trend. The economy is growing, but slowly. If that continues, the case for cutting becomes stronger, especially if inflation drifts lower over the summer. Luna: So you're saying the market is pricing in a path that the Fed isn't yet willing to acknowledge? Lucas: Yeah, I think that's exactly what's happening. And it's not unreasonable. The two-year yield is at 3.59 percent, which is below the fed funds rate of 3.62 percent. That's essentially the market saying rates will be lower a year from now. The ten-year at 4.46 percent is also down sharply from its peak. So the yield curve is normalizing — the inversion is unwinding — and that's consistent with a soft landing narrative. Luna: Before we go further, Lucas — I've had a few listeners ask me how we keep this show ad-free. And I realize I've never actually answered that. The short answer is: listener support. People who find value in what we do here chip in to keep the lights on. Nothing fancy — no paywalls, no ads. Lucas: Yeah, it's pretty straightforward. If you've been listening and getting something out of these daily conversations, you can support the show at buy me a coffee dot com slash fexingo. That's buy me a coffee dot com slash fexingo. No obligation, obviously. It just helps us keep doing this without having to sell your attention to anyone. Luna: Exactly. And we really appreciate everyone who does. Now, back to the inflation split — because I think there's another layer here. The bond market rally also reflects a global story. The ECB is still hawkish — the Bank of France governor said today they'll 'do what is necessary' on inflation. So the US isn't alone in this tightening cycle. Lucas: Right, that's a good point. Global central banks are all fighting the same enemy. But the US has a unique advantage: the dollar. As long as the dollar remains strong, imported inflation is suppressed. That helps the Fed's job. But it also means that if the Fed cuts too early, the dollar could weaken and import inflation. So there's a balancing act. Luna: And that brings us back to energy. Goolsbee's comment about persistent energy inflation — if that continues, it could keep headline inflation elevated even if core services cool. The Fed would then have to decide whether to look through energy or react to it. Lucas: Historically, the Fed does look through energy shocks because they're temporary. But this time the shock is tied to a geopolitical conflict that shows no signs of easing. So the temporary argument gets weaker. And that's why I think the market's optimism about rate cuts might be premature. The data today doesn't change the picture much — core PCE is still too high, and the labor market is still tight by historical standards. Luna: But the market is forward-looking. And the trajectory is clearly toward disinflation. The question is how fast. Lucas: Exactly. And the speed depends on two things: services inflation, which is sticky but slowly declining, and energy, which is unpredictable. If oil prices stabilize, the path becomes clearer. If they spike again, all bets are off. Luna: So what's your baseline for the next few months? Do you think the Fed cuts in September? Lucas: I think September is possible but not locked in. We need two more months of inflation data showing progress, and we need the labor market to keep cooling without falling off a cliff. The JOLTS data today was a step in the right direction. If the May jobs report shows payrolls below 150,000 and wage growth moderating, that sets the table for a cut. But if inflation reaccelerates, even temporarily, the Fed will hold. Luna: And the bond market is already pricing that in — the ten-year at 4.46 percent is below where it was a month ago. So the market is giving the Fed room. Lucas: It is. And that's the interesting dynamic. The bond market is essentially doing the Fed's work for it — tightening financial conditions through higher real rates, even as nominal rates fall. Because inflation expectations are coming down, real rates are actually rising. That's a restrictive force that the Fed doesn't have to create through rate hikes. Luna: So the market is helping the Fed. But if the economy weakens more than expected, that could change quickly. Lucas: Absolutely. If we get a bad jobs report — say, payrolls below 100,000 — then the narrative shifts from 'soft landing' to 'hard landing,' and the Fed would be forced to cut aggressively. But that's not the base case. The base case is a gradual cooling that allows for a measured easing. And the data today supports that view. Luna: Alright, so to wrap up: the PCE data today confirms that inflation is still sticky but trending down. The bond market is rallying because it sees the light at the end of the tunnel. But the Fed is unlikely to change its rhetoric until it sees more progress. And the key wildcard is energy. Lucas: That's the nutshell. And we'll be watching the May jobs report next week for the next piece of the puzzle. Thanks for listening, everyone.