Is the Fed Trapped? Stagflation Fears Grow as Inflation Holds

Fed Confronts Stagflation Risks as Policy Outlook Becomes Uncertain

The Federal Reserve begins its two-day meeting today under mounting economic pressures. While inflation showed signs of improvement earlier this year, rising tariff threats and government spending cuts are now clouding the outlook. The Fed is widely expected to keep interest rates unchanged, but with inflation still elevated and economic momentum fading, policymakers face a growing risk of stagflation—a scenario that complicates traditional policy responses.

Inflation Concerns and Rising Market Uncertainty

Recent inflation data offers mixed signals. The consumer price index dipped to 2.8% from 3%, but the Fed’s preferred inflation gauge, due later this month, is expected to remain flat. More concerning is the sharp increase in long-term inflation expectations, as reflected in the University of Michigan’s sentiment survey—the biggest jump since 1993. If these inflation fears take hold, businesses may raise prices preemptively, and workers may demand higher wages, adding to inflationary pressures.

At the same time, consumer and business confidence has deteriorated due to deepening spending cuts and job reductions. While unemployment remains low at 4.1%, a cooling labor market could add another layer of uncertainty. If hiring slows significantly while inflation remains persistent, the Fed may find itself unable to cut rates as aggressively as markets anticipate.

Tariffs and Rate Cut Expectations

Trade policy risks further complicate the Fed’s decisions. Powell has acknowledged that a single round of tariffs may have a limited inflationary impact, but if the proposed tariffs expand or escalate in multiple stages, inflation pressures could intensify. Unlike the tariff hikes of 2018–2019, which had limited impact on broad price levels, the current environment—already sensitive to supply-side shocks—could react more strongly.

Despite these risks, futures markets continue to price in three rate cuts this year—in June, September, and December. However, with inflation expectations rising, the Fed may push back against these assumptions, maintaining a more cautious stance. Powell’s post-meeting commentary will be critical in determining whether traders should recalibrate their rate expectations.

Market Outlook

With stagflation risks increasing, traders should brace for a more hawkish tone from Powell, even if rate cuts remain on the table. If inflation expectations remain elevated, the Fed may hold rates steady for longer than markets expect, creating potential downside for equities and risk assets. Bond yields could also rise as investors reassess the likelihood of aggressive monetary easing. The next key catalyst will be Powell’s press conference, which will set the stage for the Fed’s next move.

More Information in our Economic Calendar.