Federal Reserve signals stagflation risk despite market optimism
As the Federal Reserve maintains a hawkish stance amid inflation concerns, investors should look beyond Wall Street for protection against looming economic headwinds.
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Investors are choosing to turn a blind eye for now.
In an environment where markets have largely recovered from recent volatility, the world’s most powerful central bank has struck a decidedly hawkish tone in its latest policy decision. The Federal Reserve is prioritising inflation concerns over economic growth, despite recent tariff rollbacks.
Its caution highlights stagflation risks that may define the investment landscape for the rest of 2025 amid US President Donald Trump’s trade war.
Joe Unwin, head of portfolio management at Apostle Funds Management, said Fed chair Jerome Powell’s hawkish tone was at odds with the fact that markets have effectively recovered all of their losses since Liberation Day, perhaps suggesting that investors are no longer concerned about tariffs.
“The key message was that the Fed is focused on fighting inflation rather than preserving growth,” he said.
It comes as Federal Open Market Committee members revised their economic projections toward what increasingly resembles a stagflation scenario.
Their median 2025 GDP growth forecast fell from 1.7 to 1.4 per cent, while their median core PCE inflation forecast rose from 2.8 to 3.1 per cent.
Growth forecasts also fell slightly for 2026 and inflation forecasts rose for both 2026 and 2027.
Pepperstone senior research strategist Michael Brown said the FOMC’s revised economic forecast made the new “dot plot” of Fed funds rate projections “a complete mess”.
Seven FOMC members saw no more rate cuts at all, and the median forecast was revised up for both 2026 and 2026. But the dots are “of little use at the best of times, least of all a time as uncertain as this, and participants should be careful not to place too much weight on them.”
Meanwhile, GSFM investment specialist Stephen Miller noted a curious contradiction in the Fed’s messaging on economic uncertainty.
While Mr Powell emphasised uncertainty throughout his press conference, the official Fed statement noted that “uncertainty about the economic outlook has diminished but remains elevated.”
Mr Powell defended this characterisation, telling reporters: “If you think about it, tariff uncertainty, uncertainty really peaked in April. And since then has come down.”
This assessment is striking given the eruption of direct military conflict between Israel and Iran, with potential for US involvement – a geopolitical risk seemingly absent from the Fed’s calculations.
Mr Powell also cast doubt on the reliability of forecasts: “With uncertainty as elevated as it is, no one holds these rate paths with a lot of conviction.”
This remarkable de-emphasis of the Fed’s own “dot plot” projections shows even policymakers are navigating with limited visibility.
US corporate earnings forecasts have risen sharply since May as the stock market “grows into” its elevated price-to-earnings multiple. But the “unusually elevated” uncertainty outlined by Mr Powell and the drift toward stagflation evident in the FOMC forecasts is at odds with bullish market sentiment.
Mr Miller expressed surprise at what he calls “pervasive complacency in risk markets” given the uncertainties around tariffs, inflation, and the budget deficit.
“In the large continuum of outcomes that present themselves in the current highly uncertain environment, risk markets have parked themselves at the optimistic end,” he said.
The implications for investors are potentially significant. A less dovish Fed and deteriorating growth outlook suggests a prudent approach would be to increase diversification beyond US markets.
This is how respondents to BoFA’s latest fund manager survey were positioned, albeit that may set markets up for a snap back upward in the US dollar and US stocks in the near term.
“That strengthens the case to increase exposure to non-US markets so that your portfolio is sufficiently diversified in the event of weak US performance,” said Mr Unwin.
For investors seeking specific strategies, floating rate credit may be an attractive option.
“In a higher-for-longer environment, floating rate credit is an attractive way to get good returns with very low volatility. It’s protected from interest rate risk,” he added.
Moreover, there are several structural factors that may contribute to persistent US inflation pressures. Mr Miller cites the retreat from globalisation, with governments introducing protectionist measures under the guise of “industrial policy” or “national security.”
Mr Miller also highlights demographic challenges, noting that “immigration restrictions and the exit of baby-Boomers from the workforce will also add to inflation pressures via higher wage growth, absent any offsetting productivity improvements.”
Trump’s tax and spending bill currently working its way through Congress represents another risk factor. By potentially widening the already substantial US budget deficit – currently around 6.5 per cent of GDP – it could act as a further growth and inflationary spur.
“Bond investors may look askance at a US budget deficit already around 6.5 per cent of GDP,” Mr Miller warned. The tax bill “may agitate bond investors further” by adding to this deficit.
While Mr Powell has described the Fed as “well positioned to wait to learn more about the likely course of the economy,” mounting fiscal pressures could limit the central bank’s flexibility, Mr Miller said.
“In the past, quiescent inflation has allowed the Fed to respond swiftly to downdrafts in growth. In the current environment, however, ‘sticky’ inflation may yet rob the Fed of the flexibility to quickly cut rates,” he added.
Given these cross-currents, prudent investors are advised to maintain a defensive posture.
With risk assets already trading at elevated valuations, the potential for negative returns in a stagflation environment warrants caution.
Originally published as Federal Reserve signals stagflation risk despite market optimism
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