Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Fed's New Favorite Inflation Gauge Is the PCE
Transcript
- Lucas: So Luna, the Fed's favorite inflation gauge just came out, and core prices are up 3.3 percent year over year. That's the Personal Consumption Expenditures index, or PCE, and it's the one the Fed actually targets. Luna: Right, and I always forget — why does the Fed prefer PCE over the CPI that we hear about more often? Lucas: Good question. The short version is that PCE reflects actual consumer behavior better. It captures substitutions — if beef gets too expensive and you switch to chicken, PCE accounts for that. CPI uses a fixed basket. Plus, PCE includes things like employer-paid healthcare, which is a huge chunk of spending that CPI misses. Lucas: And the Fed has been explicit for decades that PCE is their target. So when the core number comes in at 3.3, that's the headline they're looking at, not the CPI print from a couple weeks ago. Luna: That makes sense. And I know you mentioned this is something our listeners really get value from — the way you break down these indicators. If today's episode helps you make sense of the Fed, consider supporting the show so we can keep doing this ad-free. You can buy us a coffee at buy me a coffee dot com slash fexingo. Lucas: Yeah, that's really kind. It does help us keep the lights on and the episodes free. So, back to the numbers — core PCE at 3.3 percent is still well above the Fed's 2 percent target. But the trend has been downward from the 4 percent plus we saw a couple years ago. Luna: And the market reaction today? The ten-year Treasury yield is around 4.67 percent, down a bit over the week. So is the market reading this as good news? Lucas: It's a mixed bag. The headline number was in line with expectations, and month over month, core PCE rose just 0.2 percent. That's the kind of pace that eventually gets you back to target. So yields dipped slightly, but the bigger picture is that inflation is sticky enough that the Fed can't declare victory yet. Luna: So what does this mean for the September meeting? Are we still on track for a cut? Lucas: The market is pricing in about an 80 percent chance of a quarter-point cut. But the Fed has been careful not to promise anything. The July jobs report was softer, and now inflation is cooling but not collapsing. They're walking a tightrope. Luna: That's the thing, right? If they cut too soon, inflation could reaccelerate. If they wait too long, they might tip the economy into recession. Lucas: Exactly. And that's why the composition of PCE matters. Services inflation, especially housing and healthcare, is still running hot. Goods prices have actually been falling. So the core number is being propped up by services. Luna: I saw that healthcare services were up something like 3.8 percent year over year. That's not going away anytime soon. Lucas: Right, and healthcare is a big reason PCE runs a bit higher than CPI sometimes, because of that employer-paid component. But the Fed knows that — they look through the noise and focus on the trend. Luna: So what's the one thing a listener should take away from today's PCE print? Lucas: That inflation is on a downward path, but it's not there yet. The Fed needs to see sustained progress toward 2 percent, and 3.3 percent is still a ways off. That means rates are likely to stay higher for longer, even if they cut a little bit in September. Luna: And the bond market seems to agree — the ten-year is still above 4.5 percent, which is historically high. Lucas: Yeah, and that's a level that a lot of investors haven't seen in over a decade. It changes the calculus for everything from mortgages to corporate borrowing. Lucas: But here's a nuance: the five-year Treasury is at 4.39 percent, and the two-year is at 3.69 percent. So the curve is steepening, which some read as a sign that the market expects the Fed to cut soon. Luna: A steepening curve — that's usually a vote of confidence in the economy, right? Or is it a warning? Lucas: It can be both. In this case, I'd say it's the market pricing in cuts because inflation is cooling, but also demanding a term premium for the massive Treasury supply we're seeing. The deficit is huge, and the Treasury has to sell a lot of debt. Luna: Speaking of which, I read that Treasury Secretary Bessent is considering tapping the Treasury General Account to fund bond buybacks. That's a pretty unconventional move. Lucas: It is, and it's got some big names skeptical — Stanley Druckenmiller has been vocal about it. The idea is to use the TGA's cash to buy back longer-dated bonds, which could help stabilize yields. But critics say it's just kicking the can down the road and doesn't address the underlying deficit. Luna: So the Fed is watching PCE, the Treasury is playing games with the TGA, and the market is trying to figure out what it all means. It's a lot to untangle. Lucas: It is, but the PCE report is the clearest signal we have. Let's dig into the actual components — what's driving that 3.3 percent core number? Luna: Please, I need to know if my grocery bill is going to stop hurting. Lucas: Ha, well, food prices are actually up only about 2 percent year over year, so that's not the main culprit. It's really shelter costs and services. Shelter is up about 4.5 percent, and that's the biggest single weight in PCE. Lucas: But here's the interesting part: market-based rent measures have been cooling for months. There's a lag effect — it takes a while for those to feed into the official numbers. So we should see shelter inflation decelerate in the back half of the year. Luna: That's promising. So the 3.3 percent might be the peak for this cycle? Lucas: Possibly. If shelter starts to fade, core PCE could drift down to 3 percent by year end, and then maybe 2.5 percent by mid-2027. That would put the Fed in a position to cut rates more meaningfully. Luna: And that would be good for stocks, right? Lower rates typically boost valuations. Lucas: Generally, yes. The S&P 500 is at 7,674, near record highs, and it's been supported by hopes of rate cuts. But if the Fed cuts and inflation reignites, that would be worse for the market in the long run. Lucas: So the Fed's credibility is on the line. They've said they want to see convincing evidence that inflation is heading to 2 percent. One or two good months isn't enough. Luna: It's like they're saying, 'Show me the trend, not just a blip.' Lucas: Exactly. And that's why the next few PCE reports will be crucial. If we get another couple of 0.2 percent monthly gains, they'll feel more comfortable. If it jumps back to 0.3 or 0.4, they'll hold off. Luna: So as an investor, what do you do with this information? Do you position for rate cuts or not? Lucas: I'd say don't get too far ahead of the Fed. The market has been wrong before. But if you believe the disinflation trend continues, then locking in longer-term bonds at current yields might be attractive. The 10-year at 4.67 percent is a decent real return if inflation keeps falling. Luna: That's a good point. And I know you can't give personalized advice, but that's a reasonable framework. Lucas: Right, it's about understanding the risks. The biggest risk to the bond market right now is a fiscal crisis — the deficit keeps growing, and if investors demand higher yields, that could push rates up even as the Fed cuts. Lucas: That's the scenario Druckenmiller is warning about. He thinks the Treasury's bond buyback plan is a distraction from the real problem. Luna: So the bond market is the real battleground, not just the Fed. Lucas: Exactly. And that's what makes this episode's topic so relevant. PCE is the Fed's compass, but the bond market is the map. And right now, they're pointing in slightly different directions. Luna: Well, I feel a lot more informed about PCE than I did twenty minutes ago. Thanks for breaking it down, Lucas. Lucas: Happy to. And remember, we'll be back tomorrow with another angle on the economy. Until then, keep an eye on those yields.