Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Two Percent GDP Trap That Has the Fed Stuck
Transcript
- Lucas: Two percent. That is the annualized real GDP growth rate we are sitting on as of the first quarter of 2026. It is not terrible — it is not great either. It is exactly the kind of number that makes the Federal Reserve's job impossible. Luna: Because two percent is right in that no-man's-land. Too slow to absorb shocks, too fast to trigger a cut. Lucas: Exactly. And look at what happened in the bond market this week. The 10-year Treasury yield dropped to 4.56 percent, down about one point four percent over five days. Meanwhile the short end — the 2-year yield — barely budged. So the yield curve is steepening, but in a way that says: the market thinks growth is softening, not collapsing. Luna: That is a bear steepener, right? Long rates falling because of weak growth expectations, not because the Fed is cutting. Lucas: Precisely. And the Fed is stuck at 3.65 percent on interest on reserve balances. They have not moved since April. They cannot cut, because core CPI is still 335.4 and creeping up — that is a two point three percent year-over-year increase, if you rough it out. And they cannot hike, because consumer sentiment just hit a record low. The University of Michigan survey this week — it is brutal. Luna: We have seen that headline. Consumer sentiment fresh record low in May, driven by Iran war fears and inflation at the pump. But here is the thing — the GDP data is from January. The CPI is from April. The sentiment data is from this week. So we are looking at a moving target, and the Fed is flying blind. Lucas: That is the real story. The economic data is like a rearview mirror, and the shocks are coming through the windshield. The 10-year breakeven inflation rate is 2.40 percent — that is what the bond market expects inflation to average over the next decade. It is up one basis point from the day before, but it has been remarkably stable around that level. So the market is not panicking about runaway inflation, but it is also not seeing a return to two percent. Luna: So the breakeven is basically saying: we will live with 2.4 percent inflation for a while. That is above the Fed's target, but not so far above that they have to act aggressively. Lucas: Right. And that is where the productivity debate comes in. If the AI economy is actually boosting productivity — and we have seen some evidence in the labor market, with job openings dropping to 6.866 million in March, down from 6.922 million — then you can have decent growth without overheating. But the consumer is not feeling it. Average hourly earnings are up to $37.40, but that is barely keeping pace with CPI. Luna: Let me play devil's advocate. The unemployment rate is 4.3 percent. That is historically low. Initial jobless claims just fell to 209,000. The labor market is tight. So is the consumer sentiment drop just noise? Or is it a genuine warning? Lucas: I think it is a genuine warning, but not about a recession next quarter. It is about a slow squeeze. Real GDP growth is two percent annualized. That is below the trend we had in the late 2010s. And nominal GDP — which is the raw dollar value of everything we produce — is $31.856 trillion. That is up from $31.422 trillion a year ago. So we are growing in nominal terms, but inflation is eating a chunk of it. Luna: That is the stagflation-lite scenario everyone is whispering about. Not the 1970s, but a persistent low-grade fever. Lucas: Exactly. And the bond market is pricing that in. The long end of the curve — the 30-year Treasury yield at 5.06 percent, down one point six percent over five days — is saying: growth is going to be mediocre, inflation is going to be sticky, and the Fed is going to stay put. The short end — the 3-month T-bill at 3.59 percent — is saying: the Fed is not moving anytime soon. Luna: So if the Fed is stuck, what breaks the logjam? A recession? A productivity miracle? Lucas: That is the billion-dollar question. And honestly, I do not have a clean answer. But if we look at the JOLTS data — job openings falling to 6.866 million — that is a sign that the labor market is cooling. Not crashing, cooling. So the Fed might get its soft landing, but it will feel like a bumpy ride. Luna: And speaking of feeling the bumpy ride, I want to mention something here. If you are listening to this and thinking, 'Okay, I am trying to make sense of all these numbers for my own portfolio or my own business', you are not alone. We get a lot of messages from listeners saying that this show helps them connect the dots. Lucas: And that is exactly why we do it — ad-free, no sponsors, no agenda. Just two people trying to figure it out in real time. If you find that useful, and you want to help keep it that way, you can support the show at buy me a coffee dot com slash fexingo. It is a small gesture that goes a long way toward keeping the lights on. Luna: Yeah, and it really does make a difference. We are not asking for much — just that if you get value from it, toss something in the hat. It keeps us independent. Lucas: Alright, back to the numbers. So the other thing that caught my eye this week is the small-cap rally. The Russell 2000 is up three point four percent over five days. That is a big move. And it suggests that investors are rotating into domestically focused companies that might benefit from… what, exactly? Luna: From a weaker dollar? From the assumption that the Fed is done hiking? Or just from the fact that large caps got too expensive? Lucas: Probably a bit of all three. But the small-cap move is interesting because it tells you that some money is betting on a 'no recession' outcome. Small caps are more sensitive to domestic growth. If you thought we were heading into a recession, you would not be buying them. Luna: So we have conflicting signals: small caps rallying, consumer sentiment tanking, bond yields falling, inflation sticky. It is like the market is trying to have it both ways. Lucas: It is. And that is why I keep coming back to the Fed. They have the unenviable task of trying to interpret all of this. The Fed funds rate is 3.64 percent effective. That is about one hundred fifty basis points above the breakeven inflation rate. So real rates are positive, but barely. Historically, that is not a restrictive enough stance to crush inflation if it gets re-accelerated. Luna: But if they hike now, they risk breaking something in the consumer sector. We have record low sentiment, credit card debt is piling up, and the savings buffer from the pandemic is gone. Lucas: Right. So they are between a rock and a hard place. And the data is not giving them a clear out. The next big print is the May CPI, due in mid-June. If that comes in hot, all bets are off. Luna: And what about the supply side? The Iran war is still rattling energy markets. Putin and Xi are talking about gas pipelines again. That is a wildcard. Lucas: Absolutely. The geopolitical backdrop is adding a layer of uncertainty that the models cannot capture. The 10-year breakeven at 2.40 percent might be artificially low if energy prices spike again. But it might also be artificially high if a ceasefire happens. So the range of outcomes is unusually wide. Luna: So for the listener trying to position their portfolio, what is the takeaway? Do you lean into the small-cap rally? Buy bonds? Stay in cash? Lucas: I think the honest answer is: diversify and don't bet the farm on any one scenario. The bond market is saying growth will slow. The stock market is saying maybe not. The consumer is saying it hurts. I am not sure any of them are fully right. But I do think the next six months will be determined by one thing: whether the productivity gains from AI show up in the GDP data. Luna: That is the wildcard. If we start seeing real GDP growth tick above two percent without inflation accelerating, then the Fed has room to cut. If not, we are in for a long, boring grind. Lucas: Exactly. And that is the macro story right now. Not a crisis, not a boom — just a slow, confusing drift. Thanks for sticking with us through the numbers. Luna: We will be back tomorrow with another episode. In the meantime, keep your eyes on the yield curve.