Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why Core PCE Keeps Sticky Above 3 Percent
Transcript
- Lucas: So the Fed's preferred inflation gauge, core PCE, hit 3.4 percent in May — that's the highest since October 2023. And the interesting thing is, this isn't a blip. It's been trending up for several months now. Luna: Right, we've talked about this a few times. But what's driving this latest reading? Is it still housing, or something else? Lucas: Housing is a big part, but actually the story this time is services inflation ex-housing. That category has been accelerating, and it's now running at about 4.1 percent annualized. That's the stickiest component. Luna: And that's exactly the kind of thing the Fed watches most closely, because services inflation tends to be driven by wages, which are harder to bring down. Lucas: Exactly. And speaking of which — you know, we keep this show free and ad-free because we think understanding these dynamics matters. If walking through the economy with us has made something click, the best way to support that is at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small gesture that helps us keep the conversation going without any sponsors or commercials. Lucas: So back to that core PCE number. The 3.4 percent reading came in a bit above consensus, and markets reacted by pricing in a slightly higher probability of a rate hike later this year. Luna: But the Fed has been saying they want to see 'greater confidence' that inflation is moving sustainably toward 2 percent. Does this reading shake that confidence? Lucas: It should, at least a little. The three-month annualized rate of core PCE is now around 3.8 percent. That's well above the 2 percent target. And the 10-year breakeven inflation rate, which is the market's expectation for average inflation over the next decade, is at 2.20 percent. That's not alarming, but it's also not signaling a rapid return to 2 percent. Luna: So the market doesn't see inflation collapsing, but it also doesn't see it accelerating. It's more like a stubborn plateau. Lucas: Exactly. And that plateau is problematic for the Fed because if they cut rates too soon, they risk re-igniting inflation. But if they hold at 3.63 percent, or even hike, they risk slowing the economy more than necessary. Luna: And the economy is still pretty strong. Real GDP growth annualized was 2.1 percent in the first quarter, up from just 0.5 percent in the prior quarter. Job openings jumped to 7.6 million in April from 6.9 million. That's a big rebound. Lucas: That JOLTS number is actually fascinating. Job openings had been trending down for over a year, and then suddenly they pop back above 7.6 million. That suggests labor demand is still robust, which puts upward pressure on wages. Luna: And average hourly earnings are up 3.7 percent year-over-year. That's above the level that many economists think is consistent with 2 percent inflation. Lucas: So you have this combination: sticky services inflation, rising job openings, solid wage growth, and a GDP that's accelerating. That doesn't sound like an economy that needs looser monetary policy. Luna: But the yield curve is still inverted. The 10-year Treasury is at 4.37 percent, the 2-year is at 4.13 percent — so the spread is about 24 basis points. That's still signaling recession risk. Lucas: Right, and the market is basically pricing in a soft landing — inflation comes down slowly, the economy avoids a deep recession. But the inversion says the bond market is more cautious. So there's a real tension. Luna: Let's talk about the goods side. Core goods prices have actually been deflating slightly. So the inflation problem is entirely in services. What's driving that? Lucas: A lot of it is what economists call 'supercore' inflation — that's services excluding housing and energy. That category includes things like healthcare, education, transportation, and recreation. And those are sectors where labor costs are a big share of the price. Luna: So if wage growth stays elevated, supercore inflation is going to stay sticky. And the Fed can't really fix that with rate hikes alone, because it's more about labor supply and productivity. Lucas: True, but they can try to cool demand enough to reduce the bargaining power of workers. That's the classic Phillips curve logic. But it's a blunt instrument. Luna: And the risk is that they overshoot and cause a recession. The unemployment rate is still at 4.3 percent, which is low historically, but if they hike too much, that could rise quickly. Lucas: The Fed's own projections from their June meeting showed that most members expect one or two rate cuts this year. But that was before the May core PCE data. Now I wonder if they'll revise that. Luna: Do you think they'll actually hike? That seems like a long shot given the political pressure and the lag effects of previous hikes. Lucas: I think a hike is unlikely unless inflation accelerates further. But the more likely scenario is that they hold rates higher for longer. The fed funds rate is at 3.63 percent, which is still below core PCE inflation of 3.4 percent in real terms. So policy is not actually that restrictive. Luna: That's a key point. Real interest rates are basically zero. Historically, the Fed has needed to push real rates above neutral to bring inflation down sustainably. Lucas: And neutral is estimated to be around 0.5 to 1 percent in real terms. So we're not there yet. That suggests the Fed may need to keep rates where they are for a while, even if inflation doesn't come down fast. Luna: What about the breakeven rate? It dropped slightly to 2.20 percent. Is that giving the Fed any comfort? Lucas: A little, but not much. A 2.20 percent breakeven means the market expects inflation to average slightly above 2 percent over the next decade. That's not a sign of de-anchoring, but it's also not a strong vote of confidence that the Fed will hit its target. Luna: So the bottom line: inflation is proving stickier than hoped, the labor market is still tight, and the Fed is in a wait and see mode, but the risk of a hike is not zero. Lucas: I'd say that's about right. And the next big data point will be the June CPI report, due out next month. If that shows another hot reading, the conversation will shift quickly. Luna: And the jobs report for June, which comes out a few days before. Nonfarm payrolls have been solid, but if we see a big miss, that could change the calculus too. Lucas: Absolutely. So plenty to watch. For now, the macro picture is one of persistent inflation, a resilient economy, and a Fed that's stuck between a rock and a hard place. Luna: And we'll be here to break it down. Thanks for listening.