The U.S. stock market has delivered exceptional performance over the past year. Compared to other developed nations, the U.S. economy has outpaced its peers, driven by relatively strong corporate earnings, elevated government spending, and rising productivity. However, financial markets are beginning to question whether this era of American exceptionalism is coming to an end. A troubling mix of slowing economic growth and rising consumer prices, also known as stagflation, threatens to halt the country’s long-standing market outperformance. It’s a scenario that both policymakers and investors are eager to avoid.
What Is Stagflation And Why It Matters in 2025
Stagflation is relatively rare because inflation and economic stagnation don’t typically occur at the same time. Falling prices usually accompany economic slowdowns, as weaker demand puts downward pressure on inflation. In response, policymakers often turn to stimulative fiscal and monetary measures such as increased government spending or lower interest rates to help jumpstart growth.
During periods of stagflation, slowing economic growth and rising consumer prices occur simultaneously. This typically results from supply-side shocks, restrictive trade policies, or poor government decisions that drive prices higher while hurting economic activity. The last major episode of stagflation in the U.S. occurred in the 1970s when oil shocks and policy missteps triggered runaway inflation and a weak economy.
A return to a 1970s-style stagflation scenario would be disastrous for investors, yet recent economic indicators suggest a similar pattern may be unfolding. While inflation has eased from its 2022 peaks, it remains stubbornly above the Federal Reserve’s 2% target. At the same time, consumer sentiment has dropped sharply, business activity is slowing as companies await clarity on trade policy, and key labor market indicators are beginning to weaken—all signs of a cooling economy.
How Tariffs Are Fueling Stagflation Concerns
Tariffs are a major contributor to the inflation outlook. According to the Federal Reserve Bank of New York’s Survey of Consumer Expectations, as of February 2025, U.S. consumers expect inflation to rise to 3.1% over the next year, the highest level recorded since May 2024. In response to the worsening outlook, investors in Treasury Inflation Protected Securities have pushed two-year breakeven inflation rates to 3.27%, up from 1.50% six months ago.
The University of Michigan Consumer Sentiment Index paints an even more concerning picture. The latest report showed a sharp rise in inflation expectations, with the one-year outlook climbing to 4.9%—the highest since November 2022—and the five-year outlook jumping to 3.9%, marking the largest monthly increase since 1993. Unlike the Fed’s survey, the Michigan index emphasizes consumers’ immediate perceptions of inflation as it relates to personal finances and current economic conditions, making its results more volatile. The most likely driver behind this shift in sentiment is uncertainty surrounding tariffs.
New tariffs, including a 25% levy on steel and aluminum imports, along with a broader reciprocal tariff policy are set to be unveiled on April 2. They are expected to raise costs for American businesses, many of which will ultimately pass those costs on to consumers. While the administration hopes these trade measures will stimulate domestic production, the near-term reality is that higher input costs will likely drive higher prices.
Consumer Sentiment Drops As Growth Outlook Dims
As inflation remains elevated, economic growth is showing signs of slowing. The University of Michigan’s Consumer Sentiment Index fell 11% last month, dropping to its lowest level since 2022.
Consumers are growing increasingly concerned about their financial prospects. Sentiment is a key indicator of future spending behavior; when confidence declines, households often scale back discretionary purchases, which can slow overall economic activity. Businesses are already adjusting their expectations in response. For example, Delta Air Lines recently lowered its Q1 2025 earnings forecast, citing weaker consumers and business demand.
Similarly, initially optimistic about pro-business policies following November’s national election, small businesses are now voicing concerns about future growth amid rising costs and ongoing policy uncertainty. After a brief period of outperformance relative to large-cap stocks, small-cap equities are struggling again. As of March 27, 2025, the iShares Russell 2000 ETF is down 7.19% year-to-date, significantly underperforming the SPDR S&P 500 ETF, which has declined 2.95% over the same period.
Labor Market Risks and Business Caution
To make matters worse, there are warning signs that employment growth may be losing steam. The Conference Board’s Employment Trends Index, which tracks hiring trends, suggests that momentum in the job market is waning.
“The ETI fell in February to its lowest level since October,” said Mitchell Barnes from The Conference Board in a press release. “Growing policy uncertainty is beginning to weigh on business and consumer sentiment, with more substantial impacts from federal layoffs and funding disruptions expected in the months ahead,” Barnes noted in the release.
As the DOGE-related federal layoffs begin to show up in the data and some private businesses respond to the new tariff regime with potential job cuts, consumer spending could take a significant hit, further reinforcing the stagflationary cycle.
The Federal Reserve Dilemma?
The prospect of stagflation puts the Federal Reserve in a particularly challenging position. If inflation continues rising, it is possible that the Fed will be forced to tighten monetary policy In that case, the central bank risks making the economic slowdown worse by increasing borrowing costs. On the other hand, if policy is eased too soon to support growth, inflation could accelerate further.
The Fed has signaled its continued commitment to bring inflation and inflation expectations under control, but rising tariffs have complicated its approach. In its most recent meeting, which concluded on March 19, Fed officials acknowledged growing economic uncertainty, prompting them to raise their inflation forecast while lowering their growth outlook.
“There is nothing more uncomfortable than a stagflationary environment, where both sides of the mandate start going wrong,” said Chicago Fed President Austan Goolsbee on March 25 on CNBC. “Higher tariffs raise prices and reduce output—that is a stagflationary impulse,” he added.
How Investors Can Prepare For Stagflation
Financial markets have responded to the rising uncertainty with increased volatility. The S&P 500, which had been approaching record highs, has pulled back by 10% from its peak as investors weigh weakening growth prospects against heightened policy uncertainty. The bond market is also showing signs of strain. Despite expectations of slower growth, bond yields have been climbing as investors demand higher returns to offset rising inflation expectations.
For investors, the threat of stagflation presents a challenging environment. Traditional equities may struggle in the face of stagnant growth, while inflation-protected sectors such as commodities and infrastructure could provide some resilience. Historically, gold and other hard assets have performed well during stagflationary periods. Gold’s recent surge above $3,000 per ounce likely reflects growing concerns about this risk.
Looking Ahead: Can the U.S. Avoid Stagflation?
Fortunately, stagflation is not inevitable. Avoiding it will require a balanced approach from the Trump administration that addresses inflation without stifling economic growth. Offering greater clarity on trade policy and implementing targeted fiscal adjustments that preserve consumer demand could help mitigate some of the key risks.
There is also the possibility that the reciprocal tariff strategy, which matches to U.S. tariffs to levies imposed by other countries, could ultimately lead to lower duties. For example, Bloomberg has reported that the European Commission is drafting a term sheet for a potential agreement with the U.S. that would include reducing EU tariffs, encouraging mutual investment, and easing certain regulations and standards. Such concessions are exactly what the Trump administration is aiming for and could help counter some of the stagflationary pressures currently at play.
The effects of federal spending cuts, revamped trade policies, and weakening consumer sentiment will take time to fully work their way through the economy. While markets may be overreacting to the threat of stagflation, the risk remains that policymakers could find themselves trapped, facing rising prices amid a slowing economy. In such a scenario, both stocks and bonds may have more downside. Stagflation is a lose-lose situation—and financial markets know it.
Read the full article here
