Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What the Fed Makes of the ECB Rate Hike
Transcript
- Lucas: So the European Central Bank hiked rates yesterday for the first time since 2023. That is not what anyone expected at the start of the year. Luna: Right, and the timing — June 11 — right after the May CPI print here showing 4.2% annual inflation. It feels like the global inflation story is tightening, not loosening. Lucas: Exactly. The ECB's move is directly tied to the Iran conflict driving up energy costs. Wholesale prices here surged 1.1% in May on energy. That's the same channel. And it puts the Fed in a tricky spot. Luna: Tricky how? The Fed's been on hold since early this year. The effective fed funds rate is 3.62%, pretty flat. Why would the ECB matter to them? Lucas: Because the Fed doesn't operate in a vacuum. When a major central bank hikes, it tightens global financial conditions. The dollar strengthens, which puts downward pressure on US import prices — that's actually disinflationary. But it also signals that the ECB sees inflation as persistent enough to need another rate increase. That reinforces the Fed's own caution. Luna: So the market reads it as: if the ECB is hiking, the Fed definitely isn't cutting anytime soon. Lucas: Right. And look at the bond market reaction. The 10-year breakeven inflation rate dropped to 2.29% from 2.34% last week. That suggests the market thinks the ECB's hawkishness will slow global growth and ultimately reduce inflation. But the two-year yield has stayed elevated. Luna: Because the near-term inflation expectations are still sticky. The May CPI — 4.2% year-over-year — is the highest in three years. Core CPI at 336.1, up from 335.42. That's not going away quickly. Lucas: And the Fed's preferred measure, core PCE, is at 129.6. It's creeping up. The question I keep coming back to is: does the Fed need to react to the ECB, or is this just noise? Luna: I think it matters because of the energy channel. The ECB hike is, at its core, about energy inflation spilling into core. The same thing is happening here. If the Fed ignores that, they risk falling behind. Lucas: But they also risk overreacting. The US economy is showing some soft spots. The UK just shrank 0.1% in April. Global growth is fragile. Hiking now would be a gamble. Luna: Let's talk about what the Fed is actually watching. They've got the FOMC meeting next week. What's the chance they move? Lucas: Near zero. The fed funds futures are pricing no change. But the dot plot could shift. If the ECB's move makes Fed officials more worried about inflation persistence, we might see the median 2026 rate projection tick up. Luna: And the statement language. They'll have to acknowledge the global backdrop without sounding alarmed. Lucas: Exactly. They'll say something like 'the Committee is attentive to global developments.' That's code for: we see what the ECB did, but we're not following yet. Luna: I want to go back to the breakeven drop. If the market believes the ECB hike will slow growth and lower inflation, why aren't stocks reacting more? The S&P is up 0.1% over five days. Lucas: Because the equity market is laser-focused on AI and tech right now. The NASDAQ is up 0.4% over five days. The Russell 2000 small caps are up 3.1%. That's a risk-on move that says: growth is slowing, but not collapsing, and the Fed staying put is fine. The ECB hike is just a headwind they can absorb. Luna: Unless energy prices keep rising. If the Iran conflict escalates, oil could spike, and then the ECB hike looks like the first of many. That would change the narrative fast. Lucas: And if it does, the Fed's 'patient' stance becomes a liability. They've been at 3.62% for months. If inflation reaccelerates, they'd have to play catch-up. That's the worst scenario for markets. Luna: So what's your base case? Lucas: I think the Fed holds through the summer. The ECB hike is a signal, but not a game-changer for US policy. The bigger story is that inflation is proving stickier than hoped, and the global growth picture is mixed. The Fed will wait for more data. Luna: That sounds reasonable. And honestly, if walking through the economy with us has made something click, you can support the show's independence at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small gesture that keeps us ad-free and focused on what matters: clear, specific analysis. No upsells, no sponsors. Luna: Exactly. So back to the Fed: what data points do you think they're watching most closely before the June 17-18 FOMC meeting? Lucas: The May CPI is already in. Next is the May PPI, which came in hot — 1.1% month-over-month. That feeds into core PCE. If core PCE for May, due out later this month, shows an acceleration, the hawks will have ammunition. Luna: And the jobs market. The May employment report showed solid job gains but a tick up in unemployment. That's a mixed signal. Lucas: Right. The Fed wants to see the labor market cool enough to ease wage pressure, but not so much that it signals recession. That's a narrow path. Luna: One thing we haven't mentioned: the ECB hike puts pressure on emerging markets. Higher rates in Europe mean capital flows out of EM, weaker currencies, and imported inflation. That could eventually feed back into US goods prices. Lucas: Good point. The Fed has to consider the spillover effects. A stronger dollar helps contain US inflation, but it hurts EM economies. And if those economies slow, US exports suffer. So there's a growth-inflation trade-off. Luna: It's a complex web. But the bottom line is: the ECB hike reminds everyone that the fight against inflation isn't over. The Fed can't declare victory yet. Lucas: And the bond market is pricing that in. The 10-year Treasury yield at 4.46% reflects the uncertainty. Not too hot, not too cold. Just waiting. Luna: I think we're in for a 'wait and see' summer. The Fed will hold, but the risk of a hike later this year is higher than the market is pricing. Lucas: Agreed. If energy stays elevated and core inflation doesn't moderate, we could see the Fed move in September. The ECB just showed they're willing to act. The Fed might follow. Luna: Let's check back after the June FOMC. Good episode. Lucas: Yeah, thanks for listening.