Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Fed's Real Rate Trap as Inflation Stays Sticky
Transcript
- Lucas: The Fed is currently sitting on a fed funds rate of about three point six three percent. Inflation, measured by CPI, is at four point two percent annually. That means the real interest rate — the rate after you subtract inflation — is negative. Luna: Negative. So effectively, borrowing costs are still below the rate of price increases. That doesn't sound like a restrictive policy. Lucas: Exactly. And that's the trap. The Fed wants to slow the economy, but with real rates negative, they're actually still providing stimulus in real terms. It's a big reason why inflation hasn't come down to target. Luna: It feels like the conversation around rates often ignores this. Everyone fixates on the nominal number — three sixty-three — but what matters is what that buys you after inflation. Lucas: Right. And look, keeping this show independent and ad-free matters to us. If walking through the economy with us has made something click, you can support the show at buy me a coffee dot com slash fexingo. No pressure, just helps us keep doing what we do. Luna: Yeah. And we're back to that negative real rate. So what does the data actually tell us about how long this can persist? Lucas: Well, let's look at the 10-year breakeven inflation rate. That's the market's expectation for average inflation over the next decade. It just ticked up to two point three one percent, from two point two nine. That's still above the Fed's two percent target. Luna: So even the bond market isn't buying the Fed's narrative that inflation will come down smoothly. Lucas: Not yet. And then you have the job openings data. JOLTS for April came in at seven point six one eight million, up sharply from six point eight eight seven in March. That's a huge jump. Luna: The labor market is still tight. Employers are desperate for workers, which keeps upward pressure on wages and, by extension, prices. Lucas: Exactly. Average hourly earnings are now thirty-seven dollars and fifty cents, up from thirty-seven forty-one. That's a year-over-year gain of about four point two percent, basically matching CPI. Luna: So workers are treading water. Their paychecks are keeping up with inflation, but not getting ahead. That doesn't exactly scream 'overheating'. Lucas: No, it doesn't. And that's the other side of the coin. The economy is growing — real GDP annualized at one point six percent in the first quarter — but it's not booming. It's kind of stuck in this low-growth, high-inflation purgatory. Luna: Which makes it really hard for the Fed. If they hike to get real rates positive, they risk tipping a fragile economy into recession. If they hold or cut, inflation stays sticky. Lucas: And to make things more complicated, the ECB just hiked rates last week for the first time since 2023. That was driven by energy costs spiking due to the Iran conflict. Luna: That puts pressure on the dollar, right? If the ECB tightens, the euro strengthens, the dollar weakens, which could push US import prices higher — more inflation. Lucas: Exactly. So the Fed is getting squeezed from both sides. Domestically, the labor market and wage growth keep inflation elevated. Internationally, higher rates abroad could feed into US inflation through currency channels. Luna: It feels like they're boxed in. What's the market pricing for the next FOMC meeting? Lucas: Right now, the fed funds futures imply about a seventy percent chance of a hold in July. But there's a growing minority betting on a hike. The effective rate has been flat at three point six two, but the overnight rate is three point six three — basically at the top of the range. Luna: So they're already at the high end. Any further tightening would require an explicit hike. Lucas: Right. And that's a big decision. The last time the Fed hiked was July 2023. They've been on hold ever since. To break that streak would send a strong signal. Luna: But what about the yield curve? We've talked about that before — it's been inverted for ages. Is it still inverted? Lucas: Yes, but it's been flattening. The two-year yield is at four point one nine percent, the ten-year at four point four seven. That's a spread of about twenty-eight basis points. Still inverted, but less than it was. Luna: So the bond market is still predicting a recession, just less confidently. Lucas: Exactly. And that creates another contradiction. The yield curve says recession, but the real rate says policy is still loose. The Fed can't resolve both signals at once. Luna: So what's the path forward? Do they just wait and hope inflation eases on its own? Lucas: That seems to be the current strategy. But the risk is that inflation becomes entrenched. The longer real rates stay negative, the more the economy gets used to cheap money. Luna: And then when they do eventually tighten, it's more painful. Lucas: Right. It's the classic central banker's dilemma. Do you act early and risk a shallow recession, or wait and risk a deeper one later? The data today suggests they're still waiting. Luna: One thing that stood out to me in the headlines — wholesale prices rose one point one percent in May, way more than expected. That's producer prices, which tend to feed into consumer prices down the line. Lucas: Good catch. The PPI surge was driven by energy, no surprise given the geopolitical situation. But it means the pipeline for consumer inflation is still full. We might see another CPI uptick in the next couple of months. Luna: So the Fed might be forced into a hike by data, not by choice. Lucas: That's the scenario that markets are starting to price in. A hike in September or December is becoming more plausible. But the Fed will be reluctant because of the growth backdrop. Luna: It's a tough spot. And not a lot of historical precedent for this combination of negative real rates, low growth, and sticky inflation. Lucas: The 1970s is the closest analog, but even then, the economy was growing faster. We're in uncharted territory in some ways. Luna: So as we look ahead to the next FOMC meeting in July, what's the one thing you're watching most closely? Lucas: The language around real rates. If Powell starts talking about the real rate being negative, that's a sign they're thinking about hiking. If he avoids it, they're likely to stay on hold. Luna: Fair point. I'll be listening for that too.