The Fed's worst nightmare: Stagflation

The threat of stagflation – a toxic combination of a declining economy combined with rising prices – can make Fed leader Jerome Powell's job much more difficult. Central bankers will need to be even more aware of financial data points before taking further steps to cut interest rates.

"The Fed is like a base runner who is stuck between first and second base on a flyball," says Matt Mattester, chief investment officer at BNY Mellon's Lockwood Advisors. "It has to be even more computer-dependent and reactionary. Higher oil prices would be a shocking one."

Forrester noted that higher oil prices are "unwelcome news" because of concerns about the weakening economies of China and Europe.

He added that if the US and China do not come to a resolution on trade and more tariffs later this year, it could lead to higher prices for many consumer goods. Along with a prolonged rise in oil prices, it could hurt the US economy.

"The biggest concern right now is how any oil price halt could come into GDP," said Forrester. "Any further shocks from trade and customs can also be stagflationary."

Expectations that Washington and Beijing will eventually reach a trade agreement have helped lift stocks recently. Moreover, oil prices have receded a little in the hope of a ceasefire between Saudi Arabia and Yemen.

But Trump has been quick with his approach to China. That's why some experts still don't rule out stagflation as a threat just around the corner.

Higher prices and a declining economy are a recipe for disaster

"On the trade front, prospects for a constructive, pro-growth speech are disappearing fast. In our opinion, this increases the odds that the Fed will eventually fight stagflation ̵[ads1]1; inflation caused by tariffs combined with a slowdown in economic growth, "Lisa Shalett, chief investment officer with Morgan Stanley Wealth Management, said in a recent report.

Of course, if stagflation backwards the head, that would be a problem for consumers. And that can be disastrous for investors – just as it was 40 years ago, when the United States was crippled by runaway gas prices and a stagnant economy.

"What does return to stagflation, similar to the late 1970s, entail in the capital market return? Throughout the 1970s, bonds and cash produced negative real returns when unexpected inflation made real interest rates negative," said Chris Brightman, partner and Head of Investment Affiliates in Research Affiliates, in a report.

Still others believe that the Fed need not be too concerned about inflation.

"I do not see stagflation as a major risk. Inflation is still low even with the tariff rates that have been imposed," said James Ragan, director of wealth management research at DA Davidson.

Consumer prices, which exclude energy and food costs since they tend to be so unstable, increased only 2.4% the year before in August. Although it is the highest rate since July 2018, it is still below the average annual wage increase of 3.2% as reported by the government in the latest Labor Report.

In other words, wage checks for workers are more than keeping pace with rising prices.

Inflation is still in control for now

"People don't really fear the potential for inflation, whether it is tariff-related or a return in commodities," said Yousef Abbasi, director of US institutional stocks and global market strategist at INTL FCStone.

"There has been more than a decade in which investors and market forecasters have talked about the potential for higher inflation and have not expressed it," Abbasi added.

Nevertheless, inflation is still a concern that traders no longer believe that another Fed cut will be a snap when it next meets on October 30. According to federal futures contracts traded on CME, prices are now investors in over 55% chance that the Fed will keep interest rates stable.

"Inflation may creep up, but we're nowhere near the doomsday scenario to get it out of control," said Joe Mallen, chief investment officer at Helios Quantitative Research.

"Still, with inflation ticking up a bit and the economy not screaming in recession, the Fed should sit back. It can wait and see. There is no need to stimulate the economy or tighten interest rates," Mallen added.

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