How Would the Federal Reserve fight “Stagflation”?

Key Takeaways

• The implementation of tariffs has raised concerns that the economic growth could slow and inflation could increase.
• If that unusual phenomenon, known as "stagflation," occurs, it poses a problem for the Fed, which has a dual mandate to keep prices under control and unemployment low.
• The Fed funds rate is the main tool the Fed has to control inflation and promote job creation, but not at the same time.
• Federal Reserve Chair Jerome Powell acknowledged that such a scenario would be a challenge for Fed.

The Federal Reserve has playbooks for fighting inflation as well as boosting the economy in times of rising unemployment. What would the central banks do if both happened at the same time.

The campaign of President Donald Trump to impose tariffs has caused some concern among forecasters that the country is heading towards stagnant economic growth and high levels of inflation. This phenomenon, known as “stagflation”, has been happening for a considerable period since the 1970s.

If this happens, the Fed would be in a difficult position. It manages the nation’s monetary policies with the dual mandate to keep inflation under control while keeping unemployment low. The Fed has a problem in that it cannot use its main tool to reduce inflation and encourage employment at the same time, which is changing the crucial fed funds rate.

The Fed raises its fed funds rate to combat inflation. It does this by increasing interest rates on all loans and slowing down the economy. This is done to reduce spending and to allow supply to rebalance. The fed did it in 2022 to combat inflation after the pandemic.

When unemployment is high, Fed can lower fed funds rate, lowering borrowing costs. Easy money tends towards making businesses boom, and employers hire more. When the pandemic hit 2020, the Fed lowered interest rates to near-zero levels. This helped revive an economy that was suddenly in a recession.

Two problems at once: The challenge of fighting them both

A reporter asked Federal Reserve Chairman Jerome Powell Wednesday about the policy-response dilemna during a news conference at which he explained that the central bank had decided to leave the Fed Funds rate unchanged following its most recent meeting.

Powell said, “That’s an extremely challenging situation for any central banks and certainly for us.” “We’ll see how far away each of these two measures is from their goal and then ask how long it will take us to get them back on track.” We will make a decision, because all of our tools are oriented in the same direction.

What does this mean in practice? According to Kathy Jones at Schwab’s chief fixed income strategist, the Fed must determine whether inflation or unemployment are the most important issues.

"If inflation is high or elevated as it is now, it focuses on maintaining a restrictive policy to counter it, even if it is concerned that unemployment may rise longer run," Jones told Investopedia in an email. "In theory, once unemployment begins to rise inflation would likely be on the decline, so the Fed could respond to that by cutting rates."

A spike in unemployment can have the opposite effect.

"The Fed might look through the inflation pressures and lower rates on the assumption that inflation would retreat," Jones said.

'Misery Index' Nowhere Near 1970s Levels

The “misery index” was created by economists in the 1970s when the economy experienced a double-whammy with low growth and high inflation. It gives a sense of the stress that stagflation can cause. The misery index is the combination of the unemployment and inflation rates, to show how difficult it is to find a job when prices are rapidly rising.

At that time, Fed chair Paul Volcker—a hero of Powell’s—chose to fight inflation first, raising interest rates so high that the economy went into a brief but severe recession in the early 1980s. Eventually, the inflation rate fell and the job markets recovered.

The “misery index” is not as high today as it was back in the 1970s and most forecasts do not show that it will be anytime soon.

The Fed's own economic projections call for the unemployment rate to rise to 4.4% by the end of 2025, up from 4.1% in February but relatively low by historical standards. Fed officials expect inflation as measured by Personal Consumption Expenditures to rise 2.8% over the year, up from a 2.7% increase in February, still above the Fed's target of a 2% annual rate but far below the 5.6% increase in June 2022 and nowhere near the double-digit levels of the stagflationary 1970s.

Both measures are worse now than when the Fed last made projections, in December. That was before Trump shook the economic outlook, by announcing steep duties on China, Canada and Mexico and then repeatedly delaying or changing them at the last moment. Until a few weeks ago, forecasts predicted a steady growth rate and gradually declining inflation.

As of now, the Fed is unaware, just like everyone else in the world, how much Trump’s tariffs are likely to increase unemployment or inflation. The Fed is waiting for the outcome of the uncertainty to determine whether unemployment or inflation will be the greatest source of misery.

Jones said, “This is especially tricky when the cause of the two disruptions is the tariff policy because that can change rapidly and unpredictably whereas the Fed’s policy changes work with “long and varied lags.” It’s no surprise that the Fed has chosen to maintain its policy, since the outlook for the future is so uncertain.