The Fed might not prevent a recession
The persistence of inflation could hinder the Federal Reserve’s ability to avert a recession. A growing concern is emerging on Wall Street: The economy could potentially contract while tariffs maintain elevated consumer prices. Worries regarding stagflation—a troubling mix of sluggish economic growth and escalating prices that complicates policymakers’ efforts to respond—are undermining stock values and driving investors towards the relative security of U.S. government bonds, resulting in a decline in Treasury yields.
Concerns among investors center on the potential impact of President Trump’s antitrade measures, which could sustain the annual rate of inflation above the Federal Reserve’s 2% target, simultaneously hindering economic growth. Given that inflation exceeds the target, the Federal Reserve is likely to hesitate in reducing borrowing costs in an effort to stimulate economic activity. Inflation and recession could potentially occur simultaneously.
Guneet Dhingra, who leads U.S. rates strategy at BNP Paribas, indicated that the risk of stagflation has emerged as a fundamental theme in the current market landscape. Many of his clients hold the belief that the Federal Reserve will intervene to mitigate economic downturns by reducing interest rates should growth falter. “These investors often overlook the reality that the Federal Reserve operates under a dual mandate, which includes a commitment to maintaining an inflation target.”
The swift pace of policy alterations is generating unease regarding key economic indicators, many of which remain reflective of January’s conditions and fail to account for the repercussions of tariffs. Recent data revisions suggest persistent inflation alongside a decline in economic activity. Concerns regarding stagflation diminished somewhat on Wednesday as the annual consumer price index for February decreased to 2.8% from 3%. This development provides the Federal Reserve with additional latitude to concentrate on the other aspect of its dual mandate, particularly in fostering robust employment levels. The comprehensive effects of tariffs on consumer pricing have not fully materialized, and additional metrics suggest a deceleration in economic activity.
In January, the figures for U.S. job openings, along with the rates of hiring and layoffs, exhibited minimal variation; however, a number of analysts are revising their projections for economic growth downward. Earlier this week, Goldman Sachs revised its gross domestic product growth projection for 2025 down to 1.7%, a decrease from the previous estimate of 2.2%. The Federal Reserve faces an intensified challenge amid a particularly complex phase for fiscal policy. The legislative chambers are currently engaged in negotiations to finalize a budget, with a House proposal suggesting a reduction in expenditures ranging from $1.5 trillion to $2 trillion. Proposals aimed at stimulating economic growth, including the potential extension of the 2017 tax cuts for both households and corporations, remain in the negotiation phase and may arrive too late to prevent an impending recession.
Market participants are exhibiting signs of apprehension. The Nasdaq Composite Index has declined over 10% from its peak in December, reflecting investor concerns regarding the future business environment. The 10-year Treasury yield stands at 4.3%, attempting to rebound from significant declines observed over the past month, driven by increased demand for low-risk investments. Market participants are increasingly anticipating that the Federal Reserve will intervene to stabilize the situation. The CME’s FedWatch tool indicates a 62% probability of three or more interest-rate reductions occurring this year.
“Amid increasing apprehensions regarding stagflation, the Federal Reserve might find it necessary to reinstate its easing cycle in the near term,” stated Nikos Tzabouras, an analyst at Jefferies-owned trading platform Tradu, in a recent note. However, this scenario may prove to be impractical, especially if the transmission of tariff prices compels the Federal Reserve to maintain its current stance for an extended period this year, according to Ed Al-Hussainy, a senior analyst at Columbia Threadneedle, in a recent report.
As is often the case, certain individuals are identifying potential opportunities. “Real yields have experienced a decline and are currently approaching levels considered inexpensive when compared to the past two years,” stated Lisa Shalett, CIO at Morgan Stanley Wealth Management, in a report released earlier this week. “The securities may represent a viable investment opportunity in a stagflationary context.”
