Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why The Fed's Rate Hikes Are Sticking
Transcript
- Lucas: If you look at the headline number for the trade deficit this month, it hit one hundred five point six billion dollars. That is the widest gap since right before the last round of tariffs kicked in, and it tells us something important about where the pressure is coming from. We have been talking about domestic demand driving inflation, but this suggests the cost side is getting squeezed by global dynamics again. Luna: Right, and when imports get expensive, that margin gets passed straight to the consumer, doesn't it? It feels like we are seeing the lag effect of the dollar staying strong while other currencies weaken. Lucas: Exactly. And you pair that with the fact that core PCE price index just ticked up to one point two percent year-over-year from the previous reading, and you start to see why the Federal Reserve isn't rushing to cut rates. The effective funds rate is holding steady at three point seven five percent, and the market seems to be accepting that this is the new normal rather than a temporary spike. Luna: It is strange because real GDP growth is slowing down to two point two percent annualized. Usually, when growth slows, inflation cools faster. Why is the inflation metric so sticky right now? Lucas: I think it is because the labor market is still surprisingly resilient despite the job openings dropping to seventy thousand and thirty-nine thousand. Average hourly earnings are creeping up, which means wage-push inflation is still in the mix. Plus, the ten-year breakeven inflation rate is sitting flat at two point three six percent, which tells me the bond market thinks the Fed will keep prices elevated until they force the issue. Luna: So the Fed is essentially waiting for the pain to hit the corporate sector harder before they move. Do you think that patience is costing them credibility if sentiment keeps slipping? Lucas: Maybe, but let's look at the S&P five hundred. It is up one point eight percent over the last five days, and the Nasdaq is even stronger at two point four percent. Investors are pricing in a scenario where the economy stabilizes, not collapses. They seem more worried about missing out on the tech rally than they are about a recession risk right now. Luna: But that rally is concentrated. The Russell two thousand is actually down point three percent. Small caps are still feeling the heat of those high borrowing costs. It feels like a bifurcated economy. Lucas: It absolutely is. And that brings me to the broader context of what the IMF chief was saying recently about artificial intelligence. She called it both a hope and a hazard for world leaders, which is a polite way of saying we don't know if AI will boost productivity enough to offset these inflationary pressures or if it will just create massive capital expenditure bubbles. Luna: That is a fair point. If AI drives a productivity boom, we could see lower costs across the board. But if it just means companies spend billions on data centers without immediate efficiency gains, it adds to the debt burden. Lucas: Precisely. And given that the interest on reserve balances is currently at three point nine zero percent, banks are making money on parking cash at the Fed rather than lending it out to small businesses. That liquidity trap is another reason why the transmission mechanism of monetary policy feels broken right now. Luna: Yeah, it’s weird. Banks have plenty of reserves, but they aren't passing that liquidity into the real economy. It’s just sitting there earning risk-free rates while the rest of us deal with sticky inflation. Lucas: Before we dig deeper into whether this productivity paradox will resolve itself, I want to take a quick second to mention how we keep this show running. If walking through the economy with us has made something click, or if you appreciate the deep dive into these macro trends, honestly, if today was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. It helps us keep the research rigorous and the ads minimal. Luna: Thanks for supporting the work, everyone. It really does allow us to spend more time on these complex data sets instead of just skimming the headlines. Lucas: Back to the productivity question. The IMF warned about AI being a hazard, but historically, technological shifts like electricity or the internet took decades to fully materialize in GDP numbers. We are only a few years into the generative AI wave, so the data might be too noisy to draw conclusions yet. Luna: Do you think the market is front-running that productivity gain? Like, are we seeing a bubble based on expected future efficiency rather than current reality? Lucas: There is definitely an element of that. Look at the capital expenditures from the major cloud providers. They are spending tens of billions on infrastructure that won't pay off for years. If the Fed keeps rates high, that financing cost becomes a drag. But if rates stay low enough, the market rewards the growth potential anyway. It’s a delicate balancing act. Luna: And that’s why the bond yields are rising even as growth slows. The yield curve is trying to price in that long-term uncertainty. The ten-year Treasury yield is up to five point two nine percent, which is quite high for a slowing economy. Lucas: Right. Normally, you would expect yields to fall when growth decelerates. The fact that they are rising suggests investors are demanding a premium for inflation risk and fiscal uncertainty. The twenty-year Treasury is even higher at five point six seven percent, showing that the long end of the curve is very concerned about the trajectory of national debt and spending. Luna: It feels like the market is punishing the government for not controlling spending, regardless of what the Fed does with short-term rates. Is that a fair assessment? Lucas: I think it is. Monetary policy can only do so much when fiscal policy is running wide open. With the trade deficit widening and nominal GDP hitting thirty-two trillion five hundred sixty-three billion dollars, the sheer scale of economic activity is masking some underlying structural weaknesses. We are growing, but we are paying for it with higher debt and persistent price pressures. Luna: So, are we looking at a period of stagnation where growth is weak but inflation remains stubbornly above target? That sounds like the worst of both worlds for policymakers. Lucas: It sounds exactly like stagflation-lite. Not the full-blown crisis of the seventies, but a prolonged period of mediocre growth and annoying inflation. The Fed’s best bet here is to hold steady and hope that external shocks don’t worsen. But with geopolitical tensions affecting supply chains, that’s a big if. Luna: What about the consumer? Unemployment is up slightly to four point two percent, but initial jobless claims are still low at one hundred ninety-seven thousand. People are still employed, so spending should hold up. Lucas: True, but credit card delinquencies are rising, and auto loan defaults are ticking up. The consumer is stretched. When they feel the pinch from those high borrowing costs, the consumption data will likely turn negative sooner than anyone expects. The lag effect is real, and it’s about to bite. Luna: So the Fed might find themselves forced to cut rates not because inflation is beaten, but because the financial system starts cracking under the weight of high debt. Is that the base case? Lucas: It’s becoming a more plausible scenario. The FOMC minutes will be key next week, but the tone is shifting from 'we need to fight inflation' to 'we need to prevent a crash.' It’s a subtle but significant change in mandate. They are trying to thread the needle between stopping price rises and avoiding a liquidity crisis. Luna: And if they miss that needle, who takes the hit first? Is it the housing market again, or is it the commercial real estate sector that is already struggling? Lucas: Commercial real estate is already in distress, so the housing market is next in line. With mortgage rates tracking the ten-year yield, affordability is at historic lows. Sales volumes are shrinking, and inventory is building up. If refinancing windows close, owners will be trapped in high-rate mortgages, reducing their disposable income further. Luna: It’s a vicious cycle. High rates kill demand, which kills price appreciation, which makes lenders nervous, which tightens credit even more. How do we break that loop? Lucas: You break it with a shock. Either a sudden drop in inflation that allows aggressive cuts, or a recession that forces the Fed’s hand. Neither option is pleasant, but it’s often how these cycles reset. The market is currently pricing in a slow drift, but nature abhors a vacuum. Luna: Do you think the AI hype is acting as a buffer against that downturn? Like, is tech spending propping up the whole index? Lucas: Temporarily, yes. Tech is driving the S&P five hundred gains, but it’s not broad-based. If the broader economy softens, tech margins will eventually compress too. You can’t have infinite growth in a finite resource environment. The productivity gains from AI need to be massive to offset the demographic headwinds we discussed earlier. Luna: Demographics are such a slow-moving variable, though. They don’t show up in monthly CPI reports. It’s easy to get distracted by the daily noise. Lucas: Agreed. But if you look at the JOLTS report showing fewer job openings, it hints at a labor market that is naturally cooling due to an aging population and changing workforce participation. We are entering a phase where labor scarcity is less of an issue than it was three years ago. Luna: So wage growth might stabilize, which actually helps the Fed’s inflation battle. Maybe the softening labor market is the friend we didn’t realize we had. Lucas: It could be. But only if it doesn’t tip into unemployment spikes. The Fed walks a razor’s edge here. One wrong move and you go from soft landing to hard stop. Given the current data, I think they are leaning toward caution, keeping rates high just a bit longer to ensure the trend is broken. Luna: High for longer, then. Until something breaks. It’s a stressful place to be for investors and homeowners alike. Lucas: It is. But it also creates opportunities for those with dry powder. Cash yields are attractive, and equities are volatile. The key is patience and not trying to time the exact turning point, because it’s rarely obvious until it’s happened. Luna: Good advice. Stay liquid, watch the data, and don’t panic when the headlines scream. Thanks for breaking this down, Lucas. Lucas: My pleasure. Let’s see if the next jobs report gives us any clues about whether that labor market cooling is accelerating or stalling. Until then, keep an eye on those bond yields.