GDP report revives stagflation fears in the market, with growing risk of a Fed rate hike seen

By Vivien Lou Chen

A combination of elevated inflation and slower U.S. growth is raising investors' concerns about a worst-case outcome

Thursday's U.S. economic data is ringing alarm bells in the minds of traders, economists and others, who are beginning to voice concerns that the world's largest economy could be shifting into a stagflation-type of environment.

Stagflation, a combination of elevated inflation and slowing economic growth, is regarded as the worst of all possible outcomes for Federal Reserve policy makers because it's much harder to address than a recession.

A recession would give the Fed reason to cut interest rates and tends to be accompanied by a trough, which the U.S. economy could grow its way out of over time. By contrast, stagflation might require rate hikes at a time when growth is already weakening, economists said.

Worries about the forward path of inflation were seen in the U.S. government-debt market and in options trading on Thursday after core PCE inflation came in at a hot 3.7% annual rate for the first quarter, even as U.S. economic growth slowed to a lower-than-expected 1.6% rate.

Read: Is another inflation scare coming? GDP data seem to say yes.

Thursday's data sent Treasury yields and inflation-adjusted yields to the highest levels since November, when Federal Reserve Chairman Jerome Powell hinted that the central bank was finished hiking interest rates, according to 3 p.m. Eastern time figures from Dow Jones Market Data and Tradeweb. Meanwhile, options on futures for the Secured Overnight Financing Rate implied a 21.4% probability of a Fed rate hike by December, up from 17% a day ago, according to senior portfolio manager Ben Emons of NewEdge Wealth in New York.

"We know inflation can be a self-fulfilling prophecy, in which expectations for higher prices can lead to higher inflation," said economist Lauren Henderson of Stifel, Nicolaus & Co. in Chicago. Even if Fed officials were worried about losing control of inflation, "they wouldn't voice it because they would do everything they can to ensure market participants that inflation will be in control with the appropriate policy."

Via phone on Thursday, Henderson said that "these three months of hotter-than-expected inflation data are not what the Fed is looking for, and I believe the probability of a first-round rate cut has been pushed out further."

She added that "rate hikes have now entered the chat, and there is a potential for rate hikes if the data continues to show higher-than-expected inflation."

Warnings about the possibility of stagflation in the U.S. have periodically popped up in 2021, in 2022 and in 2023 - only to be replaced by the narrative this year that the U.S. economy would likely remain strong as inflation probably fades. Thursday's data has unexpectedly upended that storyline, while keeping the debate alive over whether stagflation may be in store.

"It's hard to dismiss one quarter of bad inflation, but it doesn't necessarily mean a sign of things to come because inflation can lag growth," said Will Compernolle, a macro strategist for FHN Financial in New York. "Growth was so strong in the second half of last year that it likely drove first-quarter inflation."

He also said that "it's not clear where inflation momentum is going, and I still think that the underlying balance of the economy is better than it was two years ago. Inflation is kind of an inertial force that we don't fully understand, and there are a lot of mechanisms that contribute to it in one way or another."

-Vivien Lou Chen

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04-25-24 1602ET

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