The Fed Sees Stagflation Risk

With a bit of hindsight, the Fed Chair, Jerome Powell’s, May 7th press conference was perhaps the most consequential of the past few years.

His comments reinforced what we’ve been focused on for weeks: stagflation is emerging as the dominant macro risk for U.S. markets—from equities and credit to the U.S. dollar.

Rewind: What is Stagflation?

Stagflation is the double-whammy of elevated inflation and weak or negative GDP growth. It puts the Federal Reserve in a policy trap:

• If the Fed raises rates to contain inflation, it risks pushing the economy deeper into recession.

• If the Fed lowers rates to help the economy, it risks losing control of inflation.

Our base case is that the Fed will prioritize price stability, even if it means tightening into a slowdown. As we’ve repeatedly seen in emerging markets, failing to prioritize inflation has often led to hyperinflation and deep economic dysfunction. But in developed markets, the usual path has been for Central Banks to control inflation first and then promote growth, a trail that is painful but survivable.

The Powell Fed may opt for the Volcker path: crush inflation at the front, and restore growth later.

What Powell Said

Here are the quotes that stood out to us most (1):

"“Surveys of households and businesses report a sharp decline in sentiment and elevated uncertainty about the economic outlook, largely reflecting trade policy concerns. It remains to be seen how these developments might affect future spending and investment.”"

Policy uncertainty can cause investment paralysis. Since “Liberation Day” just over a month ago, the administration has introduced a wave of policy shifts: preliminary deals with China and the UK, new tariffs up to 145%, deferrals, exemptions, and revisions. This volatility is helping to push 2025 capital projects into 2026 or canceling them altogether.

"“The unemployment rate, at 4.2 percent, remains low… Wage growth has continued to moderate while still outpacing inflation.”"

Powell is signaling that employment is not a constraint right now. Core PCE (Personal Consumption Expenditures) inflation was 2.6% YoY in March (well above the Fed's 2% target) while unemployment remains inside what is considered the Fed’s “comfort zone” (CBO’s NAIRU (Non-Accelerating Inflation Rate of Unemployment) range of 4%–5%).

"“The new administration is in the process of implementing substantial policy changes... The tariff increases announced so far have been significantly larger than anticipated...”"

This is a telling admission: the Fed did not expect the scale or pace of tariff changes -- and when the Fed is caught off guard, it typically shifts into a more defensive posture.

"“If the large increases in tariffs are sustained, they are likely to generate a rise in inflation, a slowdown in economic growth, and an increase in unemployment… Our obligation is to keep longer-term inflation expectations well anchored...”"

This is the clearest signal yet. If stagflation materializes, the Fed will most likely prioritize inflation control. Powell is foreshadowing the potential for a politically unpopular tightening cycle, even if it exacerbates recession risks—reminiscent of the Volcker playbook of the early 1980s.

What It Means

We expect a more persistent hawkish tilt. The Fed has been surprised by the scale of policy shocks, and policymakers do not like surprises. Going forward, we anticipate they may:

• Build wider risk buffers into policy models
• Tighten their tolerance for inflation surprises
• Delay rate cuts well into 2026 unless inflation meaningfully softens

Stagflation Risk Is No Longer Marginal

Before “Liberation Day,” we viewed stagflation as a low-probability but high-impact tail risk. That has changed. The odds of a 5% inflation, 0% growth scenario are rising and the Fed’s reaction to that scenario likely drives GDP downwards not sideways.

Despite the recent equity rally, some traders may remain defensively positioned, for example:

• Overweight cash and short-duration fixed income
• Selective exposure to high-dividend, domestic service-sector equities
• Underweight cyclicals, EM (Emerging Markets), and rate-sensitive growth

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(1) Full Transcript is available at https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20250507.pdf

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