Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / Why the Fed's Core PCE Hit 3.4 Percent
Transcript
- Lucas: So the headline out of Thursday was that the Fed's preferred inflation gauge — core PCE — hit 3.4 percent in May. That's the highest reading since October 2023. Luna: Which is interesting because CPI for May came in at 3.1 percent, I think? So we've got this gap between the two measures widening. Lucas: Exactly. Core CPI for May was 3.3 percent, core PCE hit 3.4. That's a meaningful divergence. And it matters because the Fed has always said PCE is their true north — it's broader, it accounts for substitution, it captures more of what people actually spend on services. Luna: So the Fed's own gauge is flashing hotter than the CPI that everyone sees on the news. That feels like a big deal for rate-cut timing. Lucas: It really is. The market has been pricing in a cut sometime in the back half of the year — maybe September or December. But if core PCE is accelerating, not decelerating, the Fed's rationale for cutting gets thinner. Luna: And the Fed Funds rate is at 3.63 percent right now. Real rates are still positive, but if inflation is sticky at 3.4, the real tightening is less than it looks. Lucas: Right. Real rate — Fed Funds minus core PCE — is barely above zero. That's not exactly restrictive. So the Fed is stuck between wanting to ease and watching their preferred metric go the wrong way. Luna: Let's break down what's actually in core PCE that's pushing it higher. Because it's not the same mix as CPI. Lucas: Great question. So PCE weights things differently — it gives more weight to services like housing, healthcare, and financial services. And right now, services inflation is the stubborn part. Housing services alone — rent and owners' equivalent rent — are still running hot. Insurance, especially auto and home, is up double digits year-over-year. Luna: And those are exactly the categories that the CPI underweights, right? Because CPI uses a different survey for rent and doesn't include things like employer-paid healthcare as much. Lucas: Bingo. The Bureau of Economic Analysis, which computes PCE, uses business surveys and captures spending more comprehensively. So when insurance premiums surge or healthcare costs rise, PCE feels it more. And that's exactly what's happening. Luna: So the Fed looks at PCE and sees 3.4 percent. They look at the labor market — still tight, wages growing around 4 percent. They look at the services PMI — still expansionary. What incentive do they have to cut? Lucas: Very little, unless something breaks. And the something that could break is the consumer. We've seen retail sales soften, credit card delinquencies ticking up. If spending slows enough, that eventually feeds into weaker services inflation. But we're not there yet. Luna: And the ten-year breakeven inflation rate — that's the market's expectation for average inflation over the next decade — it's at 2.20 percent. Down a tick from last week. So the bond market isn't panicking. Lucas: No, the bond market is basically saying 'we trust the Fed will eventually get this under control.' But that trust could erode if core PCE stays elevated for another few months. If we see 3.5 or 3.6 in June or July, then the narrative shifts. Luna: Let's talk about the components. What's the single biggest driver in that 3.4 percent reading? Lucas: Housing services. Shelter inflation in PCE is still running around 5 percent year-over-year. That's down from its peak, but it's not falling as fast as the Fed hoped. Then you've got motor vehicle insurance — up 15 to 20 percent over the past year. And healthcare services, which are running about 4 percent. Luna: So it's really a services story, not a goods story. Goods prices are actually flat to slightly deflationary in some areas. Lucas: Exactly. Used car prices are down year-over-year, new cars are roughly flat. Apparel, electronics — all either flat or falling. The inflation we have left is in the services that are hardest for the Fed to fight with interest rates. Luna: Because raising rates doesn't fix a shortage of apartments or make insurance companies charge less. It's a blunt tool. Lucas: Exactly. And that's why we've seen this persistent gap. The Fed can slow demand, but supply-side issues in housing and insurance are structural. They take years to resolve. Luna: So if you're the Fed, do you cut rates anyway to support the economy, risking that inflation stays above target? Or do you hold firm and risk a recession? Lucas: That's the debate. And the data is giving them cover to wait. Core PCE at 3.4 percent is not an emergency — but it's not the 2 percent they want. I think they hold until at least the fall, and then it depends on whether services inflation starts to moderate. Luna: And the market is starting to agree. Fed Funds futures are pricing in a December cut with maybe 60 percent probability. Not a sure thing. Lucas: Walking through the economy like this — it's something we do every episode because we genuinely think it helps make sense of the world. And if that's been useful to you, we'd love it if you considered supporting the show. You can buy us a coffee at buy me a coffee dot com slash fexingo — that's buy me a coffee dot com slash f-e-x-i-n-g-o. Keeps the podcast ad-free and independent. Luna: Yeah, totally. It's a small gesture that goes a long way for us. And now back to that inflation picture — I want to ask about the international side. The Strait of Hormuz situation — does that feed into inflation at all? Lucas: It could, but it's not showing up yet. Oil prices have been relatively stable because the deal is holding for now. But if shipping confidence stays fragile, we could see higher transport costs, which eventually feed into goods prices. That would be a supply shock on top of the services inflation. Not the Fed's base case, but a risk. Luna: So the Fed is basically juggling three things: sticky services inflation, a resilient labor market, and geopolitical tail risks. No wonder they're in wait and see mode. Lucas: Exactly. And the next big data point will be the June PCE report — due out at the end of July. If that shows core PCE staying at 3.4 or going higher, the rate-cut narrative takes another hit. If it dips to 3.3 or 3.2, then the hawks loosen up a bit. Luna: So for listeners, what's the one takeaway from this episode? Lucas: The Fed's favorite inflation number is hotter than headline CPI suggests. Services inflation — especially housing and insurance — is the reason. And until those start cooling meaningfully, don't expect rate cuts anytime soon. Luna: Good way to put it. I'll be watching those June numbers. Lucas: Same. We'll be back to break them down when they drop.