Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How Funflation Is Reshaping the Feds Interest Rate Calculus
Transcript
- Lucas: So the May CPI and PCE numbers are out, and they both nudged up. Headline CPI hit 334, core CPI 336.1. The PCE price index rose to 131.5, core PCE to 130.1. Not huge moves, but in the wrong direction if you're the Fed. Luna: Right, and this is after months of people hoping inflation was on a steady downward slope. What's driving the stickiness? Lucas: There's a lot of chatter about 'funflation' — the idea that spending on experiences, dining out, concerts, travel, is keeping services inflation elevated. And the data backs it up. The Fed's preferred measure, core PCE, is still running above 2.5 percent annualized. That's not where they want to be. Luna: I saw that CNBC headline about funflation hitting home — how staying in isn't even the cost-saver it used to be. Groceries are up, but restaurant prices are up even more. So people are paying a premium for convenience and experiences. Lucas: Exactly. And that shift has implications for the Fed's rate path. Look, the ten-year breakeven inflation rate — that's the market's expectation for average inflation over the next decade — is sitting at 2.24 percent as of last week. That's above the Fed's 2 percent target. Not dramatically, but persistently. The market is basically saying inflation isn't coming down as fast as the Fed hoped. Luna: So does that mean the Fed is more likely to hold rates steady, or even hike again? Because the fed funds rate is at 3.63 percent effective — it's been flat since June. The market seems to think that's where we'll stay for a while. Lucas: The Fed's dot plot from June showed most members expect one or two cuts this year, but that was before the latest inflation prints. The funflation story makes it harder to cut. If people are still spending aggressively on services, and those prices keep rising, the Fed can't declare victory. They need to see sustained moderation in services inflation, not just goods. Luna: But isn't there a risk they overstay? The labor market is cooling — payrolls were only 57,000 in June, and the participation rate dropped. If they keep rates too high for too long, they could tip the economy into recession. Lucas: That's the classic tightrope. But the Fed has been pretty clear: they want to see more progress on inflation before they ease. And funflation is a reminder that the last mile of disinflation is the hardest. The easy gains from supply chain fixes and falling goods prices are behind us. Now it's about services, and that's more sensitive to wage growth and consumer demand. Luna: So what would it take for the Fed to actually cut? A string of softer CPI and PCE reports, or a big jump in unemployment? Lucas: I think they need to see at least three to four months of core PCE running at 2 percent or below. That would give them confidence that the trend is broken. But right now, core PCE is still at 2.6 percent year-over-year. And with funflation keeping services hot, it might take longer than the market expects. Luna: Interesting. So the market is pricing in cuts later this year, but if the data doesn't cooperate, those expectations could get pushed out. That would mean higher long-term rates, which we're already seeing — the ten-year Treasury is at 4.57 percent, up 2 percent in the last five days alone. Lucas: Right. And the thirty-year is above 5 percent — 5.07 percent. That's a signal that bond investors are demanding a higher term premium because they see inflation risk persisting. The yield curve is still inverted, by the way. The two-year is at 3.69, the ten-year at 4.57. That inversion has been in place for over a year now, which historically is a recession warning. Luna: But the economy hasn't tipped into recession yet. GDP is still growing, even if slowly. So maybe this time is different? Lucas: Maybe. But the longer the curve stays inverted, the more pressure it puts on banks and financial institutions. And the Fed is watching that closely. Chair Powell has mentioned the yield curve in past press conferences. It's one of the indicators they monitor for financial stability risks. Luna: So let's tie this back to funflation. Is the Fed actually talking about this concept internally? Or is it more of a media construct? Lucas: I think the term is media-driven, but the underlying phenomenon is real. The Fed's Beige Book, which collects anecdotal reports from business contacts, has noted that consumers are still spending on travel, dining, and entertainment, even as they pull back on big-ticket items. That shift from goods to services is exactly what keeps services inflation elevated. So in a way, 'funflation' is a useful shorthand for a structural change in consumption patterns that the Fed has to contend with. Luna: And it's not just the US. We saw China's consumer price growth weaken in June, but their producer inflation rose to a near four-year high. So globally, there's a mix of disinflationary and inflationary pressures. The Fed can't just look at domestic data in isolation. Lucas: Good point. Global supply chains affect goods prices, but services inflation is mostly domestic. And that's where the Fed's tools have the most traction. Higher interest rates cool demand for services by making borrowing more expensive and reducing disposable income. But it takes time, and people are still finding ways to spend on experiences. Luna: You know, speaking of spending on experiences, that reminds me — and this is a bit of a tangent but not really — if you find our conversations about the economy valuable, there's a way to support the show without it costing you anything extra. It's through buy me a coffee dot com slash fexingo. That's where listeners can chip in to keep us ad-free and independent. And it helps us keep digging into topics like this. Lucas: Yeah, it's a small gesture that makes a big difference for us. We love doing this, and listener support is what keeps it going. So if you're someone who looks forward to these episodes, consider throwing a coffee our way. Luna: Absolutely. And we're back to the funflation angle. So Lucas, where do you see the Fed heading in the second half of 2026? Any chance they cut rates at the September FOMC meeting? Lucas: I think it's possible but not probable. The July meeting is a lock for no change. By September, they'll have two more CPI reports and one more employment report. If those show clear cooling in services inflation and a softer labor market, they might have enough cover to cut 25 basis points. But if funflation persists, I think they'll hold through year-end. The risk of cutting too early and reigniting inflation is worse than the risk of cutting too late and causing a mild recession. Luna: So the bar for a cut is high. And the market is starting to price that in — the ten-year yield moving up suggests investors are pushing out their rate cut expectations. Lucas: Exactly. And one more thing: the ECB is also facing similar dynamics. Christine Lagarde recently left the door open to an early exit from their tightening cycle, but she's also dealing with political uncertainty in France. So central banks globally are in a similar bind — inflation isn't dead, and they're being cautious. Luna: Well, it's going to be an interesting second half. Thanks for breaking it down, Lucas. Lucas: Always a pleasure, Luna. We'll keep watching the data.