Wall Street is growing more worried about 1970s-style stagflation risks

Some Wall Street strategists are growing concerned the U.S. economy could be headed toward a 1970s-style stagflation scenario amid recent signs that progress on inflation is stalling.

Back-to-back consumer price index reports in December and January came in above estimates, fueling fears that high inflation could be more difficult to conquer than previously believed. 

"We believe that there is a risk of the narrative turning back from Goldilocks towards something like 1970s stagflation, with significant implications for asset allocation," JPMorgan chief market strategist Marko Kolanovic wrote in a note to clients at the end of February.

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Stagflation is the combination of economic stagnation and high inflation, characterized by soaring consumer prices as well as high unemployment. 

The phenomenon ravaged the U.S. economy in the 1970s and early 1980s, as spiking oil prices, rising unemployment and easy monetary policy pushed the consumer price index as high as 14.8% in 1980, forcing Federal Reserve policymakers to raise interest rates to nearly 20% that year. 

"There are many similarities to the current times," Kolanovic said. "We already had one wave of inflation, and questions started to appear whether a second wave can be avoided if policies and geopolitical developments stay on this course."

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Stagflation fears surged in 2022 as the Fed began aggressively hiking interest rates to quell raging inflation, but those mostly dissipated last year amid signs that price pressures were subsiding without a substantial hit to economic growth. 

However, there have been some signs recently that inflation is proving to be stickier than expected. While inflation has fallen considerably from a peak of 9.1%, progress has largely flatlined since the summer.

"The threat of resurgent inflation is a major reason investors should fear a potential stagflation," said Michael Arone, chief investment strategist for State Street. "Extraordinary government spending, structural imbalances in supply and demand with the labor and housing markets, deglobalization and more are contributing to inflationary pressures."

Several Fed policymakers have described the path to 2% inflation as "bumpy" in discussing their outlook for interest rates. While officials have kept the option of rate cuts on the table later this year, they have stressed there is no urgency given the surprising strength of the economy and the risk of reigniting inflation.

Investors were previously betting on a series of aggressive rate cuts this year, but they have dialed back those expectations following the hotter-than-expected inflation reports and cautious messaging from Fed officials. 

Arone warned that the Fed could be forced to adopt a higher-for-longer stance in monetary policy that ultimately weighs on growth.

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"The Fed's reluctance to reduce interest rates until it's more assured of inflation approaching 2% suggests that monetary policy will likely stay restrictive, potentially dampening economic growth," Arone said. "While the labor market shows resilience, an increase in unemployment coupled with a decelerating economy could heighten the risk of stagflation."

Hiking interest rates tends to create higher rates on consumer and business loans, which then slows the economy by forcing employers to cut back on spending. Higher rates have helped push the average rate on 30-year mortgages above 7% for the first time in years. Borrowing costs for everything from home equity lines of credit, auto loans and credit cards have also spiked.