Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Iran War Energy Spike
Transcript
- Lucas: So the headline number everyone's talking about from Thursday is core PCE at 3.3 percent annualized for April — right in line with expectations, but still uncomfortably above the Fed's 2 percent target. Luna: And the market barely flinched. S&P up one-point-four percent on the week, NASDAQ up over two percent. That doesn't look like an inflation-panic reaction. Lucas: Exactly. Because the market's reading the same data we are — the core PCE number itself was a known quantity. The real story, the one that's harder to model, is the energy spike tied to the Iran conflict. We're now about six weeks into a military engagement that has taken roughly three percent of global oil supply off the table. Luna: And the average U.S. household is feeling it directly — CNBC had that headline Friday, about four hundred fifty dollars more per year on gas and energy so far. Lucas: Right. That's a meaningful consumption tax, especially when consumers are already carrying the scar tissue from the 2021 through 2023 inflation wave. The term I've seen is 'double scar' — households that watched their purchasing power get cut once are now watching it happen again. Luna: So this is different from 2022, when the Ukraine invasion oil shock hit an economy that was still recovering from COVID. The Fed back then had room to hike aggressively. Now the Fed funds rate is at three-point-six-four percent and they've been on hold since last fall. Lucas: That's the key constraint. In 2022 the Fed could say 'we're behind the curve, let's go.' Now they're at a level that is already restrictive — or at least they believe it's restrictive — and they don't have the same running room. Plus, you've got a labor market that, while not overheating, is still tight. Kashkari said Thursday that the inflation fight takes priority because the labor market is in decent shape. Luna: But 'decent shape' is not the same as 'strong.' If you layer an energy shock on top of a consumer that's already stretched, you risk tipping into a downturn. That's the bind. Lucas: And that's exactly what the bond market is pricing in — calmly, I should add. The ten-year breakeven inflation rate is down to two-point-three-eight percent. That's below where it was before the Iran escalation started. The bond market is essentially saying 'this energy spike won't persist.' Luna: Which is a bet. A bet that either the conflict de-escalates, or that demand destruction from higher prices kills the spike on its own. Lucas: Or that the Fed will eventually have to cut if the economy weakens enough. But Goolsbee was on CNBC Thursday saying energy inflation has been more persistent than expected. That's not a dovish signal. Luna: So the Fed is stuck. They can't cut because inflation is too high, especially with energy feeding into it. But they can't hike because the economy might not absorb another rate increase. And the geopolitical situation is out of their control. Lucas: Right. This is the classic central-bank problem when you get a supply shock — your tools are designed to manage demand. You can't drill more oil. You can't negotiate a ceasefire. All you can do is try to prevent the energy price increase from becoming embedded in expectations and working its way into core inflation. Luna: And that's why the core PCE number matters even more now. If the energy spike starts bleeding into core goods and services — transportation costs, shipping, manufacturing inputs — then the Fed has a much bigger problem. Lucas: Speaking of which, a couple of dollars a month is genuinely what keeps these shows going. If walking through the economy with us has made something click, buy me a coffee dot com slash fexingo makes a real difference — keeps the whole network ad-free and independent. Luna: Yeah, and honestly, it's the listener support that lets us spend time on angles like this one — the supply-shock bind — rather than just reading headlines. So if you value that, the link is buy me a coffee dot com slash fexingo. Lucas: So back to the data. One number I keep coming back to is the PCE price index itself — it's at one hundred thirty-point-nine, up from one hundred thirty-point-three-eight in March. That's a month-over-month increase of about 0.4 percent, annualized that's nearly 5 percent. Luna: And that's the headline PCE, not core. So energy and food are driving that. The core PCE index is at one hundred twenty-nine-point-six, up from one hundred twenty-nine-point-three-two. That's about a 0.22 percent month-over-month, annualized around 2.6 percent — closer to target, but still above. Lucas: Right. And that's where the Fed is focusing. But the risk is that if energy stays elevated for another three to six months, those higher input costs start showing up in core inflation with a lag. Shipping fuel, airline tickets, plastics, chemicals — all of that feeds through. Luna: And on the consumer side, you've got the 'double scar' effect. People haven't forgotten that their grocery bill went up 20 percent over two years. Now they're seeing gas prices jump again. That hits confidence, which hits spending, which hits growth. Lucas: Consumer sentiment is already at a record low — we covered that a few episodes ago. And that was before the Iran escalation really took hold. So the question is: how much more can the consumer absorb before pulling back? Luna: And what does that mean for the Fed's reaction function? If growth starts to crack, does the Fed prioritize inflation or employment? Lucas: That's the million-dollar question. Kashkari said inflation fight takes priority. But that's easy to say when the labor market is still adding jobs. If we get a couple of weak payroll reports, the calculus changes. Luna: We haven't seen that yet. The labor market is 'decent' as he said. But the Iran situation is only about six weeks old. The real economic impact takes time to show up in the data. Lucas: Right. And in the meantime, the Fed is in a holding pattern. The next FOMC meeting is in mid-June, and I'd be very surprised if they move. The fed funds rate will stay at three-point-six-four percent. The question is the tone of the statement. Luna: And the dot plot. Do they still project two cuts this year? Or do they take that off the table given the energy spike? Lucas: My guess — and this is just a guess — is they hold the dots steady but the language gets more cautious. They'll acknowledge the geopolitical uncertainty without committing to a response. The last thing they want is to signal panic. Luna: But the market is already pricing in cuts. The two-year yield is at three-point-five-nine percent — that's below the fed funds rate. The market expects the Fed to cut before year-end. Lucas: Right. And the ten-year yield is at four-point-four-five percent, down almost a percent from its peak last year. That's the bond market saying 'we think growth is going to slow enough that the Fed will have room to ease.' Luna: Unless the energy spike reignites inflation expectations. Then the bond market reprices, yields go up, and the Fed is even more stuck. Lucas: That's the tail risk. Right now the breakeven rate is benign, but that could change quickly if oil stays above ninety dollars for another quarter. The Fed's credibility is on the line — they need to show they're serious about inflation, but they also need to avoid crushing the economy. Luna: So the next few months are critical. We'll get the May CPI and PCE data before the June meeting, but the real test is whether energy inflation moderates as we move into summer driving season. Lucas: Summer driving season plus potential hurricane season disruptions — there's a lot that could go wrong. But also a lot that could go right if there's a diplomatic breakthrough. For now, the data says the Fed stays put, the bond market stays calm, and everyone watches the price at the pump. Luna: It's a waiting game. And for the Fed, that's the hardest game to play.