Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How the Fed Reads the Core PCE Puzzle
Transcript
- Lucas: So the CPI came in a touch hot in July, core CPI up again, but the Fed's favorite inflation gauge—the core PCE price index—actually cooled in the latest reading. That gap is the whole ballgame for the next few FOMC meetings. Luna: Why does the Fed care so much more about PCE than CPI? I feel like CPI gets all the headlines. Lucas: Great question. The CPI is what most people see, but the Fed's mandate is really about the PCE deflator. The core PCE has been running below 2.5 percent for a while now, while core CPI is still above 3 percent. That's a meaningful divergence. Luna: So the Fed is looking at a different number than the one we all hear about on the news. That's confusing but also kind of reassuring? Why the difference? Lucas: There are a few technical reasons. PCE uses a different weight for housing, for one. It also captures substitution effects—when people switch from beef to chicken because beef gets expensive, PCE reflects that, CPI doesn't. And it's based on a broader survey of businesses, not just households. Luna: So which one should we be looking at if we want to guess what the Fed will do? Lucas: The core PCE is the one that matters for policy. The Fed's own forecast, the dot plot, is built around PCE inflation. If core PCE is cooling, that gives them cover to hold rates or even cut, regardless of what CPI says. Luna: And the latest reading showed core PCE actually came down? That's a big deal, right? Lucas: Yeah, the June core PCE was down to 130.3 from 130.09 a month earlier. It's not a huge move, but it's the direction they want to see. And the 10-year breakeven rate is at 2.27 percent, up a bit from 2.24. So market-based inflation expectations are well anchored, hovering around the Fed's 2 percent target. Luna: So the market isn't panicking about inflation. But then why is the Fed still so cautious? The fed funds rate is at 3.63 percent, and it hasn't moved in months. Lucas: That's the puzzle. The Fed is worried about two things: one, that the recent CPI upticks are a signal, not noise. And two, the real rate—the nominal rate minus inflation expectations—is still pretty restrictive. If inflation keeps falling, the real rate rises, and that could choke off growth. Luna: So they're walking a tightrope between fighting inflation and not triggering a recession. Lucas: Exactly. And the internal debate is whether to cut soon or wait for more data. Some officials point to the cooling PCE and say we've done enough. Others look at the CPI and say we can't ease up yet. Luna: I've heard that some Fed officials are actually talking about hiking again. Is that realistic? Lucas: There's a hawkish faction that wants to keep the option on the table, but the market is pricing in a cut by early next year. The fed funds futures suggest about an 80 percent chance of a quarter-point cut by March. So the market is on the dovish side. Luna: That's a big disconnect. The Fed says one thing, the market prices another. Lucas: It happens all the time. But remember, the Fed doesn't want to surprise the market. If they cut, it'll be well telegraphed. That's why they're all about data dependence now. Luna: So what specific numbers should we watch for over the next few months? Lucas: The next PCE report, which comes out at the end of August. And the employment cost index, which tells us about wage pressures. Also, the University of Michigan inflation expectations survey—that's a direct read on consumer psychology. Luna: And what about the 10-year breakeven? You mentioned it's at 2.27. Is that a level the Fed is comfortable with? Lucas: I think they're fine with it. It's within the range they've seen for years. Breakevens are a market-based measure, and they're not showing any inflation scare. If we saw a big spike above 2.5 percent, that would be a warning sign. Luna: So the Fed is basically in a wait and see mode, but they're leaning toward easing eventually. Lucas: Yeah, I think that's fair. The real rate is doing a lot of the work for them, and they don't want to over-tighten. Look at the two-year Treasury—it's around 4.7 percent, well above the fed funds rate. That's the market pricing in future rate cuts. Luna: Speaking of the real rate, how does the Fed actually calculate it? I always see 'real rate' thrown around. Lucas: It's the nominal rate minus expected inflation. For the fed funds rate, you'd take 3.63 percent minus the 10-year breakeven of 2.27, which gives you roughly a 1.36 percent real rate. That's historically restrictive, so it's pulling the economy down. Luna: So if inflation continues to fall, that real rate will rise even if they don't hike. That's a strong incentive to cut. Lucas: Exactly. And that's why the Fed is so focused on inflation expectations. If those stay anchored, they have room to ease. If they start to drift up, they're stuck. Luna: Has there ever been a time when the Fed cut rates with inflation above target? I feel like that's unusual. Lucas: It happens. In 2019, they cut rates even though core PCE was below 2 percent. But you're right, it's rare. Usually they want to see inflation moving toward target before they ease. That's the whole 'data dependent' thing. Luna: So the next couple of months are going to be really interesting. A couple of hot CPI prints and they might have to wait. Another cool PCE and they might move. Lucas: Exactly. And if today's episode helped you make sense of the Fed's thinking, that's the kind of clarity we hope you get here. If it was worth a coffee to you, you know where to find us—buy me a coffee dot com slash fexingo. It keeps the podcast ad-free and independent. Luna: We really appreciate that. It's a small thing that makes a big difference for us. Lucas: So, to get back to where we were—the Fed's next meeting is in September. They'll have the August jobs report and the next CPI and PCE numbers in hand. That's when we'll see if they finally pull the trigger. Luna: And if they do cut, what does that mean for the average person? Lucas: It means cheaper borrowing costs—mortgages, car loans, credit cards—eventually. But it also signals the Fed is worried about growth. So it's a double-edged sword. Luna: So we should hope for a cut but also be a little worried about what it implies. Lucas: That's the Fed's life. They can't win. But at least they're transparent about it. And that's what we try to explain each week. Luna: Alright, well, we'll keep watching the data. Thanks for joining us. Lucas: And remember, it's not about the headlines—it's about the core PCE. See you next time.