Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why Bond Markets Are Ignoring Tariff Inflation Threats
Transcript
- Lucas: So the ten-year breakeven inflation rate just dipped to two point two six percent. That's the lowest it's been in weeks. And it comes at a moment when import prices from China just hit their highest level since 2008. Luna: That's a pretty big disconnect. You would think tariff headlines would push expectations higher, not lower. Lucas: Right. But the bond market is essentially saying: 'Those tariffs? Not convinced they'll stick, or they'll be too small to matter, or the demand side is weak enough to absorb them.' The breakeven is the market's guess at average inflation over the next decade, and it's been drifting down since mid-July. Luna: And this is despite last week's import price report showing a surprise gain, with prices from China at the highest since 2008. What's the mechanism that keeps breakevens so low? Lucas: A few things. First, the bond market sees slowing global demand — look at Singapore's surprise tightening this morning. That's a small open economy worrying about oil-driven inflation, but for the US, the big driver is domestic demand softening just enough. Second, the Fed is at three point six three percent and not moving. They've made clear they want to see sustained inflation above target before acting. And so far, core PCE is creeping up — it's at one thirty point one in May — but the year-over-year rate is still below three percent. Luna: That's the key difference between CPI and PCE. CPI fell in June — three thirty two point six — but core PCE actually ticked up slightly. The Fed watches PCE. Lucas: Exactly. And PCE is heavily weighted toward services, which are less exposed to imported goods. So the tariff shock on Chinese goods might not show up in the Fed's preferred gauge as quickly. Meanwhile, the jobs market is still tight — initial jobless claims just dropped to one hundred eighty seven thousand, the lowest in months. Luna: That's almost absurdly low. And it happens alongside GDP growth that rebounded to two point one percent annualized in the first quarter. So the economy is growing, employment is strong, but inflation expectations are ebbing. The Fed must be scratching their heads. Lucas: I think they're actually quite comfortable. Chair Warsh — well, the recent headlines about his three key phrases — he's signaling patience. The market is doing the Fed's work by keeping long-term rates anchored. Ten-year Treasury yield is at four point six five percent, which is roughly in line with nominal growth expectations. Luna: But can that patience survive if import prices keep rising? The Trump administration announced a global tariff on forced labor grounds just Friday. And the generic drug tariffs start in 2028, but that's a two-year delay. Still, the direction is clear: higher costs on imported goods. Lucas: And yet the breakeven fell. The market seems to be betting that these tariffs either get negotiated down, or that the dollar strengthens enough to offset the price bumps, or that companies absorb the costs into margins. We're seeing little pass-through so far. Luna: Let's talk about that pass-through. The PCE price index is at one thirty one point five, up from one thirty point nine four. That's a month-over-month increase of about zero point four percent. If that pace continues, you'd get four point eight percent annualized. But breakevens say two point two six. Something has to give. Lucas: Yeah, the monthly numbers can be noisy. But the trend is what matters. And the market sees core PCE trending toward two point five to two point seven percent over the next year, not breaking above three. That's why the Fed is comfortable. If you look at the dot plots from June, the median projection for the fed funds rate by year-end is still around three point six, which is where we are. Luna: So we have this calm at the center. Meanwhile, Singapore — which is much more exposed to global trade — tightens. It shows the divergence in policy responses based on each economy's vulnerability. Lucas: And that's a good point. The US is relatively closed. Imports are about fifteen percent of GDP. So a tariff on Chinese goods, even a broad one, might only add a few tenths to headline inflation. The bond market is pricing that in as a one-off, not a persistent shift. Luna: But what about the jobs market? Job openings actually rose to seven point five nine four million in May. That's up from seven point five eight five million. Hires, we don't have the latest, but the quits rate is still low. That suggests workers are staying put, not chasing higher wages. That could keep wage inflation in check. Lucas: Average hourly earnings increased to thirty seven dollars sixty an hour in June. That's about a three point four percent year-over-year increase. It's solid, but not accelerating. And productivity growth has been decent, so unit labor costs aren't surging. That's another reason the bond market isn't sweating inflation. Luna: It's interesting that all this data — low jobless claims, steady earnings, modest GDP — is pointing to a Goldilocks scenario. Not too hot, not too cold. The bond market is essentially saying: we trust the Fed to keep it that way. Lucas: And the Fed is reinforcing that trust by being transparent. Kevin Warsh's recent speeches have focused on 'data dependence' and 'symmetry' — code for not wanting to overreact. If the economy does heat up, they'll move. But they're in no rush. Lucas: If you find these macro connections useful, we keep this show ad-free thanks to listener support. If today's episode clarified something, that's the link — buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to keep the conversation going without any sponsors. We appreciate it. Lucas: Back to the breakeven. The other factor is that oil prices have been volatile. Singapore's tightening was partly because of rising oil. But West Texas crude has been hovering around seventy dollars, not spiking. That helps keep inflation expectations contained. Luna: And the dollar index has been firm. A stronger dollar makes imports cheaper, which works against tariff pass-through. So there's a natural hedge. Lucas: Exactly. Now, the one risk I'm watching is the generic drug tariffs. Those are delayed until 2028, but they're signaling a shift in how the US treats pharmaceutical imports. If that becomes a broad trend, it could boost core PCE significantly a couple of years down the road. But the bond market is looking at the next twelve months, not 2028. Luna: So for now, the macro picture is: real GDP growth above trend, unemployment dropping, job openings still high, but inflation expectations drifting lower. The Fed's not going to cut, but they're not hiking either. It's a stationary policy that works as long as nothing breaks. Lucas: And nothing seems to be breaking. The yield curve is steep — two-year to ten-year spread is about eighty five basis points — which is historically normal. That suggests investors expect growth and inflation to settle into a moderate pace. No recession priced in. Luna: Which is remarkable given all the geopolitical uncertainty. Trade wars, new tariffs, Singapore tightening — yet US markets are complacent. Is that rational? Lucas: I think it's cautiously rational. The US consumer is still spending, corporate balance sheets are healthy, and the Fed has proven it can respond if needed. The bond market is basically saying: 'We see the risks, but we're not betting on them materializing anytime soon.' Luna: So what should listeners watch to see if that calm breaks? What's the canary in the coal? Lucas: I'd watch the monthly core PCE when it comes out for June. If it comes in above zero point three percent month-over-month, that could start moving breakevens higher. Also, keep an eye on the next JOLTS report to see if hires pick up. If companies start hiring aggressively, wage pressures might build. But for now, the data says 'steady as she goes.' Luna: And maybe watch what Singapore does next. If other small open economies follow, it could signal a global shift in inflation dynamics. But for the US, the story remains: tariffs in the headlines, but not in the numbers. Lucas: Exactly. The bond market is saying, 'Show me the inflation, and then I'll worry.' So far, there's no fire behind the smoke.