Despite short-lived periods of outsize volatility, it’s shaping up as another stellar year for the stock market. Since early June, the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite (NASDAQINDEX: ^IXIC) have blasted to record highs.
But the good times may be nearing an end, thanks to the Federal Reserve’s nightmare scenario, stagflation. While this economic scenario, characterized by high inflation, high unemployment, and stagnant or weakening economic growth, isn’t currently in play, the puzzle pieces that could dramatically complicate life for Fed Chair Kevin Warsh and the Federal Open Market Committee (FOMC) are taking shape.
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Several traits associated with stagflation are coming together
To begin with, trailing 12-month (TTM) inflation has been tracking above the FOMC’s long-term target of 2% for the last 65 months. Although headline inflation has eased from its three-year high of 4.2% in May, largely due to crude oil prices falling from their Iran war highs, it’s still well above Fed Chair Warsh’s and the FOMC’s comfort level.
Worse yet, evidence is mounting that Trumpflation (inflation driven by President Donald Trump’s policies) is becoming entrenched in the U.S. economy. The price stickiness of Core Personal Consumption Expenditures suggests it’ll be challenging for the Fed to stabilize prices.
We’re also seeing indications that the U.S. economy is weakening. The July jobs report featured 23,000 job losses, and wage growth of 3.2% is lagging TTM inflation. Further, annualized gross domestic product growth, as of the second quarter, is down to 1.5%.
Lastly, the unemployment rate actually fell to 4.1% in July… but there’s a catch. We’ve observed a persistent decline in the labor participation rate, which has modestly reduced the unemployment rate even as job creation has weakened.
In several respects, the puzzle pieces for stagflation are starting to come together.
Stagflation is the Federal Reserve’s worst nightmare
The reason stagflation is such a frightening scenario for the Fed is that there’s no ideal blueprint to combat it. Raising interest rates to stabilize prices risks further weakening the jobs market and can adversely impact economic growth. Meanwhile, lowering lending rates to boost economic growth can effectively pour gasoline on an inflation figure that’s already running hot.
