Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / How Oil Shocks Rewrite Inflation Rules
Transcript
- Lucas: The headlines this morning are pretty stark. Transport companies are sounding alarms on fuel prices, and analysts estimate the estimated bill for households hitting the oil and rates shock from the Iran situation is around one thousand seven hundred dollars per household. Luna: That is a massive hit to disposable income right when we were starting to see real wages stabilize. It feels like we are back in the early days of supply-side inflation. Lucas: Exactly. And the tricky part for the Federal Reserve is that this isn't demand-pull inflation where people are just spending too much. This is a cost-push scenario driven by logistics and energy. Look at the latest data. The core PCE price index is at one thirty point seven as of July, which is still above the two percent target, but the velocity of that increase has slowed. Luna: But does it matter if the Fed ignores the upstream shock? If transport costs go up, everything else follows. Lucas: It matters immensely because of how it bleeds into the core numbers. When freight rates spike, those costs eventually get embedded in the prices of services. We saw the CPI all urban consumers jump to three hundred thirty four point one in August. That includes food and energy, so it's noisy, but the core CPI ex food and energy also ticked up to three hundred thirty seven point eight. Luna: So even after stripping out the direct energy component, the underlying pressure is still there. Is that because businesses are passing through the logistics costs? Lucas: Partially, but it's also wage rigidity. Average hourly earnings for private industry were at thirty seven point eight dollars in August. When labor costs are sticky and input costs rise simultaneously, margins get squeezed or prices get raised. The Fed is watching this closely because they know you can't print more shipping containers. Luna: Right. You can raise the fed funds effective rate, which is sitting flat at three point six three percent, but you can't force more oil into the pipeline or lower diesel prices. Lucas: Exactly. And look at the ten-year breakeven inflation rate. It's at two point three eight percent as of yesterday. That means the bond market is pricing in slightly more long-term inflation than the Fed's two percent goal. Investors are worried that these supply shocks will have persistent effects. Luna: It reminds me of the trade war inflation shock we discussed earlier. Geopolitics always seems to win against monetary policy in the short run. Lucas: It does. But let's look at the broader context. Real GDP growth annualized was one point five percent in the April quarter, down from two point one percent. The economy is slowing down. So we have stagflationary pressures—slowing growth combined with rising prices due to external shocks. Luna: That makes the Fed's job incredibly difficult. They usually fight inflation by cooling the economy, but if the economy is already slowing, cutting rates might just feed the fire without solving the supply issue. Lucas: Precisely. And raising rates further could deepen the recession. The unemployment rate is holding steady at four point one percent, which is not terrible, but initial jobless claims are down slightly to two hundred six thousand. The labor market is resilient, which keeps wage growth alive. Luna: So we have a labor market that supports consumption, but a supply chain that is getting hammered by geopolitics. How do we break that cycle? Lucas: We don't break it with interest rates alone. We wait for the supply side to normalize. Until fuel prices come down, transport costs will remain high. The UK inflation jumping to three point one percent as energy costs soar shows this is a global phenomenon, not just a US problem. Luna: It really highlights the interconnectedness of the global economy. A conflict in the Middle East affects energy prices in Europe, which affects shipping costs globally, which affects inflation here. Lucas: Right. And notice the divergence in the yield curve. The ten-year treasury yield is at four point nine seven percent, while the three-month bill is at three point nine five percent. The market is telling the Fed that short-term rates need to stay higher for longer to anchor expectations, even if growth is weak. Luna: But doesn't that high short-end rate hurt borrowers? Consumers are already feeling the pinch with that estimated one thousand seven hundred dollar bill. Lucas: It does. And mortgage rates haven't dropped as fast as some hoped. The VIX is calm, but the underlying tension in the macro environment is real. We are seeing a shift where financial conditions are tightening not just because of policy, but because of risk premiums attached to geopolitical instability. Luna: So the Fed is essentially fighting a rear-guard action. They have to keep rates restrictive enough to prevent second-round effects, but not so restrictive that they crash the labor market. Lucas: That's the tightrope. And remember, the interest on reserve balances is at three point six five percent. Banks are earning good returns on their reserves, so credit creation isn't being strangled entirely. But commercial banks are wary of lending into a uncertain energy landscape. Luna: It feels like we are waiting for a signal that the oil shock has peaked. Are there any indicators that suggest the worst is over? Lucas: Not yet. The JOLTS job openings rose to seven thousand two hundred seventy one thousand in July. Demand for workers is still there, which means wages stay up. Until we see a drop in job openings or a rise in layoffs, the labor market will continue to support inflation. Luna: So the solution has to come from the supply side. More production, more logistics capacity. But that takes time. Lucas: It does. And in the meantime, consumers are absorbing the pain. The one thousand seven hundred dollar figure is an estimate, but it likely understates the cumulative effect of higher insurance, higher freight, and higher energy bills across all categories. Luna: It's a reminder that inflation isn't just a number on a screen. It's a tangible drag on living standards that policy can only mitigate, not instantly erase. Lucas: Absolutely. And that's why the Fed is being cautious. They know that once inflation expectations become entrenched, it's much harder to bring them down. The current data suggests they are staying the course, keeping the fed funds rate at three point six three percent and monitoring the CPI releases closely. Luna: So we watch the next CPI report to see if the core numbers start to decouple from the energy shock. That will be the key test. Lucas: Exactly. If core inflation starts to fall while energy remains volatile, then the Fed can breathe easier. But if core sticks, we are looking at a prolonged period of restrictive policy. Luna: I think many investors are betting on that decoupling happening sooner rather than later, but the transport sector's warnings give me pause. Lucas: It's wise to be skeptical. The market likes clean narratives, but the reality is messy. Supply chains are physical, and physics doesn't care about your P/E ratio. Luna: True. Well, before we wrap up, I want to mention something important about the show itself. If walking through the economy with us has made something click, a couple of dollars a month is genuinely what keeps these going. You can support us at buy me a coffee dot com slash fexingo. Lucas: It really helps keep the research deep and the ads away. We appreciate every listener who contributes. Now, back to the macro picture. Luna: Right. So, given the current stagnation in growth and the persistence of core inflation, do you think the Fed will hold rates steady through the end of the year? Lucas: I think they will hold. The risk of cutting too early and letting inflation rebound is greater than the risk of holding too long. With the fed funds rate at three point six three percent, they have room to maneuver if things deteriorate sharply, but for now, patience is the best strategy. Luna: Patience in an impatient market. It will be interesting to see how the S&P 500 reacts if the ten-year yield stays near five percent. Lucas: It will be a test of valuation. Companies with strong pricing power will survive; those dependent on cheap capital will struggle. For now, we stay vigilant on the energy front. Luna: Agreed. Thanks for helping us navigate the noise, Lucas. Let's see what the next few weeks bring.