Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Fed's Quiet Watch on the UK Economy's Shrinkage
Transcript
- Lucas: The UK economy shrank 0.1 percent in April. That was the headline out of London on Friday, and I think a lot of us focused investors shrugged it off—oh, it's just Britain, it's a post-Brexit mess, whatever. But the Fed pays attention to this, and I want to explain why. Luna: Because UK inflation expectations tend to lead US ones by about six months, right? Lucas: Exactly. Historically, when UK consumers start expecting higher inflation, US consumers follow. And when the UK economy hits a soft patch, it often previews a similar pattern here, especially when both are dealing with the same external shock—in this case, the Iran conflict driving up energy costs. Luna: So let's connect the dots. The UK shrank 0.1 percent. That is a contraction, albeit a tiny one. And the ECB just hiked rates for the first time since 2023, specifically because of energy-driven inflation. Lucas: Right. The ECB move on Thursday was a big deal—it broke a long pause. And here in the US, we just got a May CPI print of 4.2 percent annual, highest in three years. Core CPI came in at 336.1, up from 335.42. The PPI for May surged 1.1 percent on energy. So the same supply shock is hitting us, but the Fed is sitting at 3.62 percent on the effective fed funds rate, and the market thinks they're done hiking. Luna: But if the UK is already shrinking, doesn't that argue against hiking? I mean, if you raise rates to fight inflation, you risk tipping the economy into recession. Lucas: That is the exact debate inside the FOMC right now. The dovish camp says: look at the UK, look at the flattening yield curve—the ten-year Treasury is at 4.49 percent, the two-year is at 4.21 percent, that's not a huge spread. The economy is slowing. Don't over tighten. The hawkish camp says: but inflation is still 4.2 percent, the labor market is still tight, and if you don't act now, inflation expectations become unanchored. Luna: And where does the UK fit into that? Because the UK's problem isn't just energy. They have a weak pound, a tight labor market, and their own fiscal mess. Lucas: Sure, but the common thread is the energy price shock. The US ten-year breakeven inflation rate just ticked up to 2.31 percent from 2.29. That means bond markets expect inflation to average above 2.3 percent for the next decade. The Fed's target is 2 percent. So the breakeven is drifting away from target. The UK's breakeven is probably even higher. And when a country with that kind of inflation expectation actually sees its economy contract, it forces a question: can central banks really afford to ignore supply-driven inflation? Luna: Because normally the playbook is 'look through energy shocks, they're transitory.' That's what they said in 2021. And we all know how that turned out. Lucas: Exactly. And that's why the Fed is watching the UK numbers closely. If UK inflation stays sticky even as the economy shrinks, that is stagflationary. And if the Bank of England feels forced to hike into a contraction, the Fed takes notice. Luna: So what are the actual odds that the Fed moves again this year? The fed funds rate is at 3.62, the market is pricing a cut by September, but the data doesn't support that right now. Lucas: Look at the small-cap rally. The Russell 2000 is up 3.1 percent over the last five days. That is a bet on rate cuts—small companies are more sensitive to borrowing costs. The market is saying the Fed will cut. But the CPI and PPI data say inflation is accelerating. So someone is wrong. Luna: And the UK data adds a wrinkle. Because if the Fed cuts and inflation stays high, they lose credibility. If they hold and the economy slows, they get blamed for a recession. Lucas: Right. And the UK is the canary. If the canary stops singing, you don't ignore it. So I think the Fed is in a 'wait and see' mode, but with a lean toward hawkish. The next FOMC meeting is in July, and they'll have another CPI print by then. But the real wildcard is energy prices. If Iran tensions escalate further, all bets are off. Luna: One thing I want to underscore: the UK contraction was only 0.1 percent. That is essentially flat. So we are talking about a very small signal. But the Fed looks at these things because they don't want to be behind the curve. Lucas: And it's not just the UK. The ECB hike, the Chinese startup funding cracks—there are multiple stress points globally. The Fed's job is to keep US inflation in check without breaking the economy, and the global backdrop is getting more complicated by the week. Luna: So if you are listening and trying to make sense of where rates are headed, what is the one thing to watch? Lucas: The ten-year breakeven inflation rate. If it stays above 2.3 percent, the Fed cannot cut. If it drops back below 2.2, then maybe they have room. That single number captures the market's expectation of future inflation, and it's the most direct way to see if the Fed is winning or losing the credibility battle. Luna: And if the UK economy continues to shrink, do you think that changes the breakeven here? Lucas: Ironically, it could push it lower if investors think global demand is weakening and that will eventually pull down energy prices. But that's a risky bet. For now, the breakeven is edging up, and that is the hawkish signal. Luna: So the Fed is basically in a box. And the UK is just the latest reminder of how tight that box is. Lucas: It really is. And I think that's the story for the next few months: the Fed trying to navigate between sticky inflation and slowing growth, with global shocks complicating every decision. Luna: You know, if walking through the economy with us has made something click—whether it's understanding breakeven rates or why the UK matters—then it might be worth considering supporting the show. Lucas: We keep this podcast ad-free, and listener support is what makes that possible. If you find value in these conversations, you can help keep them going at buy me a coffee dot com slash fexingo. Luna: And honestly, it makes a real difference. So thank you to everyone who already does. Lucas: Absolutely. So back to the Fed's box—one other data point from this week: the interest on reserve balances rate is 3.65 percent, just a hair above the effective fed funds rate. That's technical, but it tells you the Fed is still in control of the floor, not in emergency mode. Luna: But if the economy slows more sharply, that floor might need to come down. And then you have a whole new set of questions. Lucas: Exactly. And that is why we will keep watching the UK, the breakeven, and the next CPI print. For now, the Fed is on hold, but the data is not cooperating. Luna: Great episode. Thanks, Lucas. Lucas: Thanks, Luna. We will be back soon with more.