Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Fed Faces a 3.6 Percent Fed Funds Rate While Inflation Runs at 4.2 Percent
Transcript
- Lucas: The Federal Reserve is currently sitting on a fed funds rate of 3.62 percent. Headline CPI just came in at 4.2 percent. Do the subtraction, and you get a real fed funds rate of roughly negative 0.6 percent. That is not exactly what you would call restrictive policy. Luna: So the famous 'higher for longer' narrative — it's not really higher in real terms, is it? Lucas: Exactly. The nominal rate is 3.62, but with inflation running at 4.2, the real rate is deeply negative. And this is not a one-month blip. Core CPI is at 336.1, up from 335.42 a month ago. The trend is clearly sticky. Luna: Meanwhile the ECB just hiked for the first time since 2023. That's a big deal. They raised rates because the Iran conflict is ramping up energy costs. The headline on Thursday was literally that. Lucas: Right. The ECB finally acted. But across the Atlantic, the Fed hasn't moved since it cut rates in late 2024. And with wholesale prices surging 1.1 percent in May — more than expected, driven by energy — you have to wonder if the Fed is now behind the curve. Luna: Let's talk about that wholesale number. The producer price index rose 1.1 percent month over month. That's annualising to something like 13 percent if it persisted. Energy is clearly the culprit, but it's still flowing through. Lucas: Yeah, and you can see it in the breakeven inflation rate. The 10-year breakeven is now at 2.31 percent, up from 2.29 just a day earlier. That's the market's expectation for average inflation over the next decade. It's creeping up. Luna: So the market is starting to price in higher inflation expectations, while the Fed is sitting at 3.62 percent, and the real rate is negative. That seems like a disconnect. Lucas: It is a disconnect. And I think it goes to the heart of the neutral rate debate. Pre-pandemic, the neutral rate — the rate that neither stimulates nor restricts the economy — was estimated around 2.5 percent. Now, with inflation at 4.2, some economists argue the neutral rate has risen. But even if neutral is now 3 percent, a 3.62 nominal rate with 4.2 inflation is still stimulative. Luna: Meaning the Fed is effectively easing even as inflation is above target. That's the exact opposite of what central bank doctrine says. Lucas: Precisely. The Fed's own projections from the March SEP showed the median dot at 3.9 percent for end of 2026. But the market is pricing in cuts. The 2-year yield — which is sensitive to rate expectations — is at 4.21, down 1.6 percent over the last five days. That suggests the bond market thinks the Fed will cut. Luna: But if inflation stays at 4.2, they can't cut. They'd be cutting into a inflation fire. So either the market is right and inflation comes down, or the market is wrong and we get a surprise hold or even a hike. Lucas: That's the tension. The Fed is in a box. They don't want to trigger a recession by hiking into a slowdown — real GDP growth annualised is only 1.6 percent, up from 0.5 but still weak. But they also can't ignore inflation at 4.2. And the energy shock from Iran is not going away quickly. Luna: You mentioned the real GDP number — 1.6 percent annualised. That's not strong. And the unemployment rate is at 4.3 percent, which is low historically. But jobless claims just ticked up to 229,000. So the labor market is still tight, but there are cracks. Lucas: Right. And average hourly earnings are up to $37.50, which is a 2.4 percent year over year increase. That's not accelerating massively, but it's not falling either. Combined with sticky inflation, that's a recipe for the Fed to stay on hold. Luna: So the message from the data is: inflation is sticky above 4, the labor market is tight but softening slightly, growth is moderate, and the real fed funds rate is negative. That seems like a recipe for a prolonged hold, not cuts. Lucas: I agree. And I think the market is mispricing the Fed's reaction function. The fed funds futures are pricing in a cut by September. But look at the core PCE — that's the Fed's preferred measure. Core PCE is at 129.6, up from 129.32. It's still trending up. The Fed cannot cut into rising core PCE. Luna: Unless the energy shock fades. If the Iran situation de-escalates, oil prices could drop, and headline inflation could fall quickly. But that's a big if. Lucas: It is. And the ECB hike suggests European policymakers expect the energy shock to persist. They wouldn't have hiked unless they were worried about second-round effects. That should be a warning sign for the Fed. Luna: So what should the Fed do? Hike? Hold? Signal a cut? What's the right move here? Lucas: I think the Fed will hold at the June meeting. They'll acknowledge inflation is sticky, point to energy, but they won't want to spook markets. They'll keep the door open for cuts later, but the data will force them to stay patient. The risk is that by holding, they let real rates stay negative for too long, and inflation becomes entrenched. Luna: That's the classic 1970s mistake. Arthur Burns kept rates too low for too long. Paul Volcker had to jack them to 20 percent to break the back of inflation. Are we repeating history? Lucas: I don't think we're at Volcker levels yet. But the parallel is uncomfortable. The Fed has been reluctant to tighten because of the growth slowdown. But if inflation expectations become unanchored, they'll have to act more aggressively later. The breakeven inflation rate ticking up is a warning sign. Luna: And the 10-year Treasury yield is at 4.49 percent, down 1.4 percent over five days. That's the market pricing in a slowdown, not inflation. So the bond market is sending a different signal than the inflation data. Lucas: Exactly. The bond market is betting on a recession that brings inflation down. But if that recession doesn't materialise, or if it's mild, then inflation stays elevated. And the Fed is stuck. This is the macro conundrum of 2026. Luna: You know, it's fascinating to walk through all this data and connect the dots. I think a lot of our listeners really appreciate having a framework to think about these numbers. It's something we try to do every day. Lucas: Yeah, I hope it helps. And you know, we're able to do this without any ads or sponsors. We deliberately don't run ads on these episodes. If you want to support that choice and help us keep the podcast independent and ad-free, the link is buy me a coffee dot com slash fexingo. No pressure, but it does make a difference. Luna: Absolutely. It keeps the show focused on the data and the analysis, not on selling you something. So if you find value in these conversations, that's the way to support us. Lucas: Alright, back to the macro. One more thing I want to highlight: the JOLTS data showed job openings surged to 7,618,000 in April, up from 6,887,000. That's a big jump. It suggests the labor market is still tight, despite the unemployment rate holding at 4.3 percent. Luna: So the Beveridge curve — the relationship between vacancies and unemployment — is still shifting. More vacancies for the same unemployment rate means the labor market is less efficient matching workers to jobs. Lucas: Exactly. And that's another reason for the Fed to be cautious. A tight labor market can feed into wage inflation, which then feeds into services inflation. The core PCE is already moving up. If wages accelerate, the Fed will have no choice but to tighten. Luna: So the big picture: inflation is sticky, the labor market is tight but softening, growth is moderate, and the real fed funds rate is negative. The ECB is hiking, the Fed is on hold. The risk is that the Fed waits too long and has to play catch-up. Lucas: That is the risk. And the bond market is not pricing that in. If the Fed is forced to hike, it will be a shock. But for now, the base case is hold through the summer, maybe a cut in December if inflation falls. But given the data, that seems optimistic. Luna: We'll be watching the Fed's June statement closely. Thanks for joining us on The Macro Memo. Lucas: See you next time.