Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What Falling Core CPI Means for the Fed Rate Path
Transcript
- Lucas: The June CPI report landed just over a week ago, and while headline inflation eased, the number that has the Fed's attention is actually hiding in the services sector. Core CPI slipped by a hair—down to 336.1 from 336.12—but that's basically flat. Luna: Flat after months of gradual decline. So what's the Fed seeing that the headline doesn't capture? Lucas: Right. The measure they're really watching is what some economists call 'supercore'—services inflation excluding housing. That's things like haircuts, auto repairs, hotel rooms, medical visits. And that number has been sticky, around 4.5 percent annualized in recent months. Luna: Which is way above the Fed's 2 percent target. So the core print might look like it's flattening out, but the engine of inflation is still running hot underneath. Lucas: Exactly. And that's why the market is still pricing in a hold at the July FOMC meeting. The fed funds rate is at 3.63 percent right now, and the futures market sees less than a 30 percent chance of a cut before September. Luna: Let's talk about what's driving that supercore stickiness. Is it labor costs? Lucas: Partly. The labor market is still tight—wages in services are growing around 4 to 5 percent year-over-year. But there's also a demand story. The World Cup gave bars and restaurants a boost last month, according to the Fed's own Beige Book. And consumers are still spending on experiences, even as goods spending softens. Luna: So the 'funflation' we talked about a few episodes back is still alive and well. But there's another data point that complicates the picture: import prices from China just posted their biggest gain since 2008. Lucas: Yeah, that headline from last Friday caught my eye. Import prices overall surprised to the upside, and Chinese goods costs hit their highest level in 18 years. That's a direct input into a lot of consumer goods—electronics, clothing, toys. Luna: Which raises the question: is the Fed's inflation battle about to get a second wind from the trade side? Lucas: That's the fear. The Fed has been hoping that goods deflation would offset services inflation. But if import prices start rising again, especially from our largest trading partner, that calculus shifts. The 10-year breakeven inflation rate ticked up to 2.24 percent last week—still below the 2.5 percent threshold that would really spook the Fed, but it's moving in the wrong direction. Luna: So the bond market is starting to price in a bit more inflation risk. What does that mean for the rate path? Lucas: It means the Fed has less room to cut than they might have hoped. If you look at the dot plot from the June meeting, the median projection was for one or two cuts in the second half of 2026. But that was before the import price surprise and before services inflation refused to budge. Luna: Right, and we've also got the wholesale prices deflating—PPI dropped 0.3 percent in June. That's the deflation side of the story. But the Fed has made clear they care more about the consumer side, especially services. Lucas: Yeah, and that's exactly the tension. You've got goods deflation from falling gasoline and some commodities, but services inflation is persistent. The Fed's favorite measure, core PCE, actually ticked up in May to 130.1 from 129.67. So the trend is not clearly downward. Luna: Let's zoom in on one specific sector: auto repair and maintenance. That's been a big contributor to services inflation. Why? Lucas: A couple of reasons. First, cars are getting more complex—more electronics, more sensors—so repairs take longer and cost more. Second, labor shortages in skilled trades. Mechanics are in high demand, and their wages are rising. Third, insurance costs are up, and that flows through to repair bills. It's a perfect storm. Luna: And that's not something the Fed can fix with interest rates. You can't raise rates and suddenly create more mechanics. Lucas: That's the key insight. Monetary policy is a blunt tool. It works best on demand-driven inflation. But a lot of the current services inflation is supply-side—labor shortages, supply chain shifts, regulatory costs. The Fed can slow the economy to reduce demand, but that risks a recession without necessarily fixing the supply issues. Luna: So where does that leave the July FOMC meeting? They meet next week, July 28-29. Lucas: Almost certainly a hold. The fed funds rate at 3.63 percent is already restrictive. The question is the language in the statement. Will they acknowledge the supercore stickiness? Will they mention the import price data? I think they'll stick with a cautious tone, emphasizing that they need to see more progress on services inflation before easing. Luna: So the bar for a cut is pretty high. And that's something our listeners should keep in mind when they see the next CPI or PCE print. Lucas: Right. And you know, it's conversations like this that make me appreciate how much nuance there is in economic data. We try to bring that clarity every episode. And if you find value in that—if walking through the economy with us has made something click—we want you to know we deliberately keep these shows ad-free. No sponsors, no commercials. If you'd like to support that choice, the link is buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to keep the podcast independent and focused on what matters: the actual numbers and the stories behind them. Lucas: Exactly. Now, back to the Fed. One other thing I'm watching is the 5-year breakeven rate, which is sitting at 2.1 percent. That's lower than the 10-year, which suggests the market expects inflation to moderate in the near term but then pick up again later. That's a steepening curve dynamic, and it usually precedes rate cuts. Luna: Interesting. So the bond market is essentially betting that the Fed will have to cut eventually, but not because inflation is licked—because the economy might slow down enough to warrant it. Lucas: Precisely. And that's the tricky balancing act. If the Fed cuts too soon and inflation reaccelerates, they lose credibility. If they wait too long, they could tip the economy into recession. The data we've seen so far in July—import prices, wholesale deflation, consumer spending—is giving them mixed signals. Luna: What are you watching between now and the July meeting? Any specific releases? Lucas: The advance Q2 GDP estimate comes out on July 30, right after the FOMC decision. That will be a big one. Also, the July consumer sentiment index from the University of Michigan—that has inflation expectations embedded in it. If long-run expectations start to drift above 3 percent, that's a red flag. Luna: And the personal income and outlays report for June, with the PCE data, comes out August 1. That's the one the Fed really cares about. Lucas: Exactly. So the next two weeks are packed. But for now, the takeaway is: don't judge the inflation picture by headline CPI alone. The Fed is looking at the sticky parts of the economy—the services you buy every week—and those are still running hot. Luna: And that's why the rate path is uncertain. Thanks, Lucas. Good breakdown. Lucas: Thanks, Luna. We'll keep watching the data.