Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why Wholesale Inflation Is the Fed's Real Headache Now
Transcript
- Lucas: So the May CPI number got all the headlines this week — 4.2 percent annual inflation, highest in three years, that was the story. But I actually think the more important number dropped yesterday. Luna: You mean the PPI print — the one that came in way hotter than expected? Lucas: Exactly. Producer prices rose 1.1 percent in May alone. That's double what economists were looking for. And the driver is pretty clear — a surge in energy costs, directly tied to the escalation with Iran. Oil's been climbing, natural gas too, and that flows through the supply chain before it ever hits the consumer price index. Luna: Right, and the thing about PPI is it's a leading indicator. If producers are paying more now, consumers will feel it in a month or two. Lucas: If walking through the economy with us has made something click for you, a couple of dollars a month is genuinely what keeps these going — buy me a coffee dot com slash fexingo, if you've gotten something out of them. Luna: Yeah, it's a small thing that makes a big difference for us. Lucas: So let's dig into why this wholesale inflation number matters more than the CPI headline right now. The core CPI actually came in a little softer than expected — excluding food and energy, it rose 0.2 percent. But the PPI surge was broad-based. Energy was the big one, but we also saw gains in transportation and warehousing, in chemicals, in some food categories. Luna: And the bond market seems to be buying the transitory story again. The ten-year breakeven inflation rate dropped to 2.29 percent — that's down from 2.34 a week ago. So bond traders are actually pricing in lower inflation expectations even after the CPI and PPI prints. Lucas: That's the fascinating tension. The inflation data is hot, but the bond market is saying 'we don't think this lasts.' Part of that is the Iran situation — energy shocks tend to be temporary unless they trigger a wage-price spiral. And part of it is the ECB. They hiked rates this week for the first time since 2023, which strengthens the euro and weakens the dollar. A weaker dollar makes our imports more expensive, but it also means the Fed doesn't have to tighten as much to achieve the same effect on financial conditions. Luna: So the ECB is doing some of the Fed's work for them? That's an interesting frame. Lucas: It's a real factor. The Fed has been on hold since they cut rates last year — the effective fed funds rate is 3.63 percent, and they've been happy to stay there. But the Iran conflict has reintroduced supply-side inflation pressures that monetary policy can't really address. You can't hike rates to drill more oil or calm shipping lanes. Luna: Which is why the PPI number is so telling. Producer prices capture those supply-side frictions before they get passed through. And for small businesses especially, that's a real squeeze. Their input costs go up immediately, but they can't raise prices overnight without losing customers. Lucas: That's the part that doesn't show up in the CPI. The CPI measures what consumers pay, but the PPI measures what businesses pay. And when you look at the details, the PPI for intermediate demand — goods that are still being processed — rose 1.4 percent. That's the stuff that becomes finished goods later. So there's a pipeline of cost increases working its way through the economy. Luna: And the Fed's favorite inflation gauge, the core PCE, is running at 2.8 percent annualized based on the latest data. That's still above their 2 percent target. So they're not going to cut rates anytime soon, even if the bond market is pricing in cuts later this year. Lucas: Right. The fed funds futures are pricing in about two quarter-point cuts by December. But after this PPI number, I think that timeline gets pushed back. The Fed is data-dependent, and the data is showing sticky inflation at the wholesale level. Chair Powell has been clear — they need to see sustained progress on inflation before they ease. A one-month PPI spike doesn't change the trend, but it's a warning that the path down is going to be bumpy. Luna: Especially with energy prices where they are. The breakeven inflation rate dropping to 2.29 percent is interesting — it suggests the market thinks the PPI spike is temporary. But if the Iran situation escalates further, that could change quickly. Lucas: And that's the risk. The bond market is pricing in a soft landing — no recession, inflation gradually coming down, the Fed cutting maybe twice. But the PPI data is a reminder that the economy is still dealing with supply shocks. The manufacturing recession that never ended, as we talked about a few episodes ago, is still weighing on activity. But input costs are rising anyway. That's a strange combination — weak output but high costs. Luna: It's like a mini version of 2022, but without the demand boom. Back then, we had stimulus-fueled demand and supply chain disruptions. Now we have geopolitical supply disruptions and relatively subdued demand. Real GDP growth is only 1.6 percent annualized. Lucas: Exactly. And that creates a dilemma for the Fed. If they hold rates steady, inflation might stay elevated because of supply costs. If they hike, they risk crushing an already fragile economy. So they're stuck in 'wait and see' mode, watching the data. The next big number is the May core PCE, which comes out in a couple of weeks. That'll tell us whether the PPI pipeline is actually translating into consumer price increases. Luna: And the JOLTS data from April showed job openings jumped to 7.6 million, up from 6.9 million. That's a big increase. The labor market is still tight, which gives the Fed another reason to be cautious about cutting. Lucas: The labor market is definitely not breaking. Unemployment is 4.3 percent, payrolls are growing, hourly earnings are up 3.3 percent year-over-year. That's a healthy labor market. But it's also one that could sustain consumer spending even if prices are rising. The worry is that if inflation expectations become unanchored, you get a wage-price spiral. We're not there yet, but the PPI number is a reminder that the risk hasn't disappeared. Luna: So what should listeners watch for in the next few weeks? Beyond the core PCE? Lucas: I'd watch the weekly jobless claims numbers. They ticked up to 229,000 this week — still low historically, but the trend has been creeping higher. If claims start to rise more consistently, that would signal the labor market is softening, which could change the Fed's calculus. Also watch energy prices. If the Iran situation de-escalates, the PPI spike will reverse, and the Fed will have more room to cut. If it escalates, we could see another leg up in inflation. Luna: And the yield curve — it's still inverted, but less so. The two-year yield is at 4.19 percent, the ten-year at 4.46 percent. That's a narrow inversion. Historically, when the curve un-inverts, a recession follows within a year or so. But we've been waiting for that recession for a while now. Lucas: The curve un-inverting without a recession would be a new one for the record books. But honestly, every cycle is different. The post covid economy has defied a lot of historical patterns. Maybe this is another one. The key takeaway from this week is that inflation is still the story, but it's a more nuanced story than the CPI headline suggests. The real action is in the pipeline — in the costs that businesses are absorbing before they get to consumers. Luna: And those costs are being driven by geopolitics, not by excess demand. That makes the Fed's job harder, because they can't control it. Lucas: Exactly. So we'll be watching the data, and we'll keep you posted. That's it for today's episode. We'll be back tomorrow with more.