Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching Energy Inflation Closely
Transcript
- Lucas: So the core PCE came in at 3.3 percent for April, right in line with expectations. That's not the headline though. The real story is what Chicago Fed President Austan Goolsbee said the next day. Luna: He called out energy inflation as more persistent than expected. That part of the report is getting a lot more attention than the core number itself. Lucas: Exactly. Look, the Fed's preferred inflation gauge — Core PCE — has been hovering around 3.3 percent for a few months now. That's sticky but not accelerating. But energy is the wild card. Goolsbee basically said that energy costs are proving harder to shake than the models predicted. Luna: And that matters because energy feeds into everything. It's not just at the pump — it's transportation, manufacturing, home heating. If energy stays elevated, it puts upward pressure on core goods and services over time. Lucas: Right. And the April CPI data showed energy prices ticking up again. The overall CPI index hit 332.4, up from 330.29 in March. That's about a 3.2 percent annualized pace. And while energy is volatile month to month, the trend is clearly not cooperating with the Fed's desire to cut rates. Luna: Meanwhile, Minneapolis Fed President Kashkari said the inflation fight takes priority because the labor market is 'in decent shape.' So the message from the Fed is consistent: no rate cuts until we see more progress. Lucas: And the market has largely accepted that. The fed funds rate is still at 3.64 percent effective, and the daily rate is basically flat at 3.62 percent. There's no expectation of a move at the next meeting. But here's the interesting tension: the ten-year yield is at 4.45 percent, down about two and a half percent over the last five days. Luna: So the bond market is actually rallying a bit, even as inflation remains sticky. That seems contradictory on the surface. Lucas: It does. But I think what's happening is the market is pricing in that the Fed will stay on hold and that inflation is not accelerating into a new leg higher. The ten-year breakeven rate is at 2.39 percent, flat. So inflation expectations are anchored. The bond market is saying 'we believe the Fed can hold the line without having to hike again.' Luna: Still, the ten-year yield has not broken above 5 percent, even with all this sticky inflation. That's been a ceiling for a while now. Lucas: Correct. The long bond yield, the thirty-year, is at 4.99 percent, down about one and a half percent over the last five days. And the five-year is at 4.16 percent. So the curve is still deeply inverted by any historical standard. The two-year yield is at 3.59 percent, actually up a tick. Luna: That inversion — short-term yields below longer-term yields — is normally a recession signal. But we've been living with this inversion for over a year now, and the economy is still growing. It's like the signal is broken. Lucas: Kashkari might push back on that. He said the labor market is 'in decent shape,' but he also said the inflation fight takes priority. That implies the Fed is willing to risk a downturn if it means getting inflation back to 2 percent. They are not going to cut rates just because the yield curve is inverted. Luna: That puts small caps in an interesting position. The Russell 2000 is up 3.3 percent over the last five days, outperforming the S&P 500's 1.6 percent gain. Small caps are more sensitive to borrowing costs, so if the Fed stays on hold, that's a headwind. But if the economy keeps growing, they might catch up. Lucas: And that's the bull case for small caps — that they've been left behind and now they're playing catch-up. The Russell is at 2,937, not far from its highs. But the question is whether energy inflation and higher rates will eventually bite their margins more than large caps. Luna: Speaking of energy — I want to get into what specifically Goolsbee might be seeing. Is it crude oil prices, or is it something more structural like refining capacity or grid constraints? Lucas: I think it's a mix. Crude oil has been range-bound around $70 to $80 a barrel, but retail gasoline prices have been creeping up because of refinery maintenance and seasonal demand. Also, natural gas prices are up about 30 percent year to date, and that feeds into electricity costs for businesses and households. Luna: So it's not just one factor. And that makes it harder for the Fed to look through energy inflation as 'transitory.' They can't just say it's a temporary supply shock when it's persistent across multiple energy sources. Lucas: Exactly. And this is where the Fed's communication is really important. Goolsbee going on CNBC to say energy is 'more persistent than expected' is a signal that the Fed is paying close attention. It's also a way of managing expectations — don't expect rate cuts anytime soon because energy is acting as a floor under inflation. Luna: Meanwhile, the ECB is also dealing with inflation. The Bank of France governor said this week that the ECB 'will do what is necessary.' So it's not just a US story — central banks globally are still struggling with price stability. Lucas: Right. And that reinforces the idea that this inflation cycle is global. Supply chains, energy markets, labor shortages — these are not purely domestic issues. The Fed can't just wish them away. Luna: I want to pivot slightly to what this means for the average American. The CNBC piece over the holiday weekend highlighted that people are feeling inflation's pinch, especially on energy and food. The headline numbers might be sticky at 3.3 percent, but the lived experience is higher for many households. Lucas: That's a crucial point. The official Core PCE strips out food and energy. But those are exactly the categories that hit consumers hardest. So when the Fed says 'core inflation is at 3.3 percent,' the person filling up their tank and buying groceries is experiencing something closer to headline CPI, which was running at 3.2 percent annualized in April, but with energy rising faster than the average. Luna: By the way — this is the kind of thing that makes us glad we do this show ad-free. We're not trying to sell you anything or push a product. We just want to help make sense of these numbers. If you find that useful and want to support the show, you can do that at buy me a coffee dot com slash fexingo. No pressure, just an option if it's something you believe in. Lucas: Yeah, that's exactly right. We keep the show free and independent because we think that's the right way to do it. And listener support is what makes that possible. So thanks for being here. Luna: So back to energy — if oil prices stay where they are and natural gas continues to rise, what's the threshold where the Fed might actually have to acknowledge that energy is not just a temporary blip? Lucas: I think they already have. Goolsbee's comments are that acknowledgment. But the question is whether it changes policy. For that to happen, we'd need to see energy inflation feeding into core inflation more directly — like higher transportation costs pushing up the price of goods, or higher utility costs pushing up rent and services. Luna: Are we seeing that yet? The core PCE is still at 3.3 percent, not accelerating. So maybe the pass-through is limited so far. Lucas: That's the optimistic view. But it's worth watching the next few months. If energy stays elevated through the summer driving season and into the fall, we could see more pass-through. And then the Fed's job gets harder. Luna: Which brings us back to the yield curve. The ten-year at 4.45 percent is actually a bit lower than it was a month ago, even with sticky inflation. That says the bond market is not panicking. But if energy inflation accelerates, that could change quickly. Lucas: Yeah, the ten-year breakeven at 2.39 percent is actually a little below where it was in April. So inflation expectations are well-anchored for now. But the Fed has to keep it that way. That means no rate cuts until they're absolutely sure inflation is sustainably heading to 2 percent. Luna: And the labor market gives them that luxury. Kashkari said it's 'in decent shape.' So they can afford to wait. Lucas: Exactly. The Fed is in a holding pattern. And the wild card — energy — is not going away anytime soon. So we're likely looking at rates on hold for the rest of the year, unless something breaks. Luna: Or unless energy prices finally cool off. But with global demand still strong and supply constraints, that's not the base case. Lucas: Right. So the takeaway for listeners: the Fed is watching energy like a hawk. Goolsbee's comments are a signal. Core PCE at 3.3 percent is not good enough, and energy is making it harder to get that number down. Until we see meaningful improvement, don't expect rate cuts. Luna: And keep an eye on the yield curve — it's still inverted, but it's not screaming recession yet. That's a strange place to be, but it's where we are. Lucas: We'll keep tracking it. Next week we'll dive into the May jobs report and see if the labor market is as 'decent' as Kashkari thinks.