How Would The Federal Reserve Fight 'Stagflation?'

The Federal Reserve has a playbook for fighting inflation, and another for boosting the economy when unemployment is rising. But what would the central bank do if both happen at the same time?

President Donald Trump’s campaign of imposing tariffs has raised fears among some forecasters that the economy is headed towards stagnant growth and high inflation, a phenomenon popularly referred to as “stagflation” that has occurred over an extended period since the 1970s.

If that happens, it would pose a dilemma for the Fed, which manages the nation’s monetary policy with the dual mandate of keeping inflation under control and keeping unemployment low. The trouble for the Fed is that it can use its main tool, changing the all-important fed funds rate, to lower inflation or encourage employment, but not both at the same time.

When inflation is running too high, the Fed raises the fed funds rate, pushing up interest rates on all kinds of loans and slowing the economy, aiming to reduce spending and allow supply and demand to rebalance. The fed did this in 2022 to combat the post-pandemic surge of inflation

When unemployment is high, the Fed can lower the fed funds rate, pushing down borrowing costs. Easy money tends to make business boom and employers hire more. The Fed chopped interest rates to near zero when the pandemic hit in 2020, reviving an economy that had suddenly plunged into a recession.

The Challenge of Fighting Two Problems at Once

A reporter asked Federal Reserve Chair Jerome Powell about the policy-response dilemma Wednesday during a press conference where he explained the central bank’s decision to leave the fed funds rate unchanged at its most recent meeting.

“That’s a very challenging situation for for any central bank, and certainly for us,” Powell said. “What we say that we’ll do is we’ll, we’ll look how far each of those two measures is from its goal, and then we’ll ask how long we think it might take to get back to the goal for each of them. And we’ll make a judgment, because our our tools work in one direction.”

What does that mean in practice? According to Kathy Jones, chief fixed income strategist at Schwab, the Fed would have to try to figure out the sequence of events, and whether inflation or unemployment is the most urgent priority.

“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 jump in unemployment could provoke the opposite response.

“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

When the economy took the double-whammy of low growth and high inflation in the 1970s, economists developed the “misery index,” giving some idea of how stressful stagflation is to experience. The misery index is a combination of the unemployment rate and the inflation rate, in recognition of how miserable it is to struggle to find work while prices are rising rapidly.

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, inflation fell and the job market recovered.

To be sure, the “misery index” today is nowhere near as high as it was in the 1970s, and most forecasts don’t show it getting there 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.

Still, both measures are now worse than they were the last time the Fed made projections in December, before Trump shook up the economic outlook by announcing steep tariffs on China, Canada, and Mexico, and then repeatedly delaying and altering them at the last minute. A few months ago, forecasts called for gradually falling inflation and steady growth.

Currently, the Fed, like everyone else, is in the dark about the extent of Trump’s planned tariffs, or how much they’ll push up unemployment or inflation. Amid the uncertainty, the Fed is waiting to see whether inflation or unemployment will emerge as the biggest source of potential misery.

“This is particularly tricky when the cause of both disruptions is tariff policy since that can change quickly and unpredictably while the Fed’s policy moves work with ‘long and variable lags,’ Jones said. ” It’s not surprising then that the Fed chose to keep policy steady since the outlook is so uncertain.”