Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How Tariffs Are Reshaping Fed Rate Decisions
Transcript
- Lucas: The S&P 500 is sitting at 7,519 after a 2.3% weekly gain. The Russell 2000, though, is up more than 6% over the same stretch. That gap is worth pausing on because it tells you something about where the market thinks the economy is heading — and it's not exactly what the Fed wants to hear. Luna: Small caps rallying while large caps lag — that's usually a risk-on signal. But given the backdrop, I'm not sure it's that simple. Lucas: It's not. And this is where the tariff story collides with monetary policy. Look, the Fed is stuck at 3.64% on the effective federal funds rate. Core CPI came in at 335.4 in April, up from 334.17. That's not the kind of inflation that lets Chair Warsh ease, even if the economy starts to soften. Luna: Let's talk about the tariff channel specifically. Because if you're a small-cap company that mostly sells domestically, a tariff on imported steel or electronics components raises your input costs — but you might also be insulated from retaliatory tariffs on exports. That's a different calculus than for a multinational like Apple or Caterpillar. Lucas: Exactly. And the Russell 2000 is up 6.3% this week — that's roughly triple the S&P 500's move. Some of that is catch-up from being beaten down earlier in the year. But some of it is a bet that the trade war, especially with China and now the Iran-related supply disruptions, is going to stay localized to certain sectors. That's a fragile thesis. Luna: We try to make sense of this kind of crosscurrent every day, and we do it without running ads. If walking through the economy with us has made something click, and you want to support keeping this ad-free, there's a simple way. It's buy me a coffee dot com slash fexingo. No pressure, just know it helps. Lucas: Yeah, and we mean that. No ads means we can talk about things like why the ten-year breakeven rate is at 2.40% without worrying about a sponsor's comfort zone. So if you find that valuable, the link is there. Back to tariffs — the bond market is basically saying inflation expectations are anchored but elevated. That 2.40% breakeven is above the Fed's 2% target, and it's been sticky. Luna: Right. And the ten-year yield itself — 4.49%, down a bit this week — is not pricing in a recession. It's pricing in a growth slowdown with persistent inflation. That's the stagflation-lite scenario. Lucas: Which is exactly what tariffs do in a textbook sense. They're a supply shock. They raise the price level, reduce real output, and leave the central bank in a bind. You can't cut rates to stimulate growth because inflation is still above target, and you can't hike to fight inflation because growth is already wobbling. Luna: So what's the Fed actually doing? We've got the effective rate flat at 3.64% since April, and the interest on reserve balances is at 3.65%. The Fed is on hold. But the data keeps moving. Lucas: Core PCE, the Fed's preferred gauge, came in at 129.3 in March, up from 128.9. That's month-over-month creep. And the headline PCE is 130.3. Those are not alarming numbers in isolation, but they're moving in the wrong direction given that the Fed wants to see disinflation. Luna: And this is before the full impact of the latest round of tariffs on Chinese goods and the Iran-related energy disruptions. The Putin-Xi talks about reviving the stalled Russian gas pipeline — that's a signal that energy markets are being reshaped geopolitically. That feeds into inflation expectations. Lucas: It does. And it feeds into the bond market's vigilance. The ten-year yield touched 5% not long ago; it's now at 4.49%. That's a meaningful decline, but it's not a collapse. The thirty-year is at 5.03%. The curve is steepening, which usually means the market expects growth to pick up or inflation to stay sticky. Tariffs contribute to both. Luna: There's also a consumer sentiment angle. Sentiment hit a record low in May, per the University of Michigan survey, driven by Iran war fears and inflation worries. That's the demand side. If consumers pull back, that's disinflationary. But tariffs push prices up on the supply side. So the net effect is ambiguous. Lucas: Which is why the Fed is in a holding pattern. Chair Warsh has been pretty clear — he's watching the data, and he's not going to preemptively cut. The bond market tested him earlier this year, and he held the line. But now the composition of inflation is shifting. It's less about services and housing, more about goods and energy. That's the tariff imprint. Luna: Let's get specific. What goods are seeing the biggest price increases? The CNBC piece over the holiday weekend mentioned food and energy as the biggest pinch points for consumers. That's classic tariff plus supply shock. Lucas: Right. Food prices are up because of grain disruptions from the Black Sea and energy costs for transport. Energy prices are up because of the Iran situation and the refinery constraints. Tariffs on steel and aluminum are feeding into appliance and auto prices. So you get a broad-based increase that hits lower-income households hardest. That feeds into sentiment, which feeds into spending, which feeds into GDP. Luna: And the Fed's mandate is dual — maximum employment and stable prices. On employment, the labor market still looks solid, but we don't have the May jobs report yet. If that softens, the pressure on the Fed to cut will grow, even if inflation hasn't come down. Lucas: That's the dilemma. And it's why the small-cap rally is interesting. The Russell 2000 is up 6.3% this week. Some analysts argue that small caps are a hedge against tariffs because they have less exposure to international supply chains. Others say it's just a rotation out of overvalued mega-caps. I lean toward the latter — but either way, it's a bet that the Fed won't have to hike again. Luna: But if tariffs keep pushing core inflation higher, the Fed might have to tighten further. That would hurt small caps more because they're more sensitive to interest rates — they carry more floating-rate debt. Lucas: Exactly. So the rally in small caps is a bit contradictory. It's saying 'risk on' in an environment where the central bank is stuck and inflation is sticky. I think the market is pricing in a soft landing where tariffs are negotiated down and inflation fades. But that's a hope, not a baseline. Luna: Meanwhile, the ECB is also in hawkish mode. The Bank of France governor said they'll 'do what is necessary' to tame inflation. That puts global central banks in a synchronized hold pattern. No one wants to be the first to cut. Lucas: And that synchronization reinforces the dollar's strength. A strong dollar helps contain import prices, which is disinflationary for the US. But it also hurts emerging markets and US exporters. So it's another layer of complexity for the Fed. Luna: Let's bring it back to the ten-year yield. It's at 4.49%, down from near 5% a few weeks ago. What drove that decline? Flight to safety because of the Iran conflict, or genuine belief that inflation is peaking? Lucas: I think it's a mix. The flight to safety bid is real — when geopolitical tensions spike, investors buy Treasuries. But there's also a sense that the economy is slowing enough that the Fed will eventually cut. The breakeven rate at 2.40% suggests the market expects inflation to average above 2% for the next decade, but not dramatically so. That's consistent with a tariff-induced level shift, not a spiral. Luna: So the bond market is basically saying: we'll tolerate 2.4% inflation if the Fed doesn't have to hike again. That's a fragile equilibrium. Lucas: Very fragile. Because if one more supply shock hits — say, a further escalation in the Middle East or a new round of tariffs — that breakeven could jump to 2.6 or 2.7, and the Fed would have to respond. Warsh has already shown he's willing to hold rates high. He's not going to capitulate easily. Luna: And the market knows that. The fed funds futures are pricing in a cut by year-end, but it's not a sure thing. The probability is maybe 50-60%. That leaves a lot of room for disappointment. Lucas: Which brings us back to where we started: the Russell 2000 rally is expressing optimism that the worst of the tariff and inflation shocks are behind us. But the data — core CPI at 335.4, core PCE ticking up, breakevens at 2.40 — doesn't fully support that. It's a market that wants to believe in a soft landing, but the Fed's hands are tied as long as tariffs are in place. Luna: So the real question might not be about the Fed at all. It's about trade policy. If tariffs come down, the Fed can cut. If they stay up, the Fed is stuck. Lucas: That's the takeaway. The Fed's next move depends more on what happens in Geneva or Beijing or Tehran than on the next CPI print. And that's an uncomfortable place for a central bank that likes to project control. Luna: Uncomfortable for investors too. Because you can't model geopolitics the way you model consumer spending. Lucas: No, you can't. And that's the real risk here — that the market is underestimating how persistent the tariff-driven inflation could be. If that's the case, the bond market vigilantes will be back, and the ten-year yield will test 5% again. And the Fed will have to decide whether to break the glass. Luna: Let's hope they have a fire extinguisher handy. Lucas: Right. For now, they're just watching the smoke.