Stagflation—a mix of high inflation, stagnant growth, and rising unemployment—is especially tough for policymakers because the usual tools for fighting inflation can worsen unemployment, and tools for boosting growth can worsen inflation. The Federal Reserve has limited tools (mainly monetary policy), but here are the main options and trade-offs it faces:
1. Re-anchor Inflation Expectations
Why: If inflation expectations rise, workers demand higher wages and firms raise prices, creating a spiral.
How: The Fed may need to keep policy rates restrictive (higher interest rates) to show it prioritizes price stability.
Risk: Higher rates slow demand and investment, which could deepen stagnation.
2. Target Supply-Side Issues (Indirectly)
The Fed cannot fix supply shocks (like oil shortages or supply chain breakdowns), but it can work with fiscal authorities by:
Signaling to Congress and the administration that structural policies (energy, productivity, labor supply) matter.
Avoiding overreaction to supply-driven inflation while still preventing inflation from spreading into wages/services.
3. Calibrate Policy More Flexibly
Instead of rigidly pushing rates higher until inflation falls, the Fed could:
Tighten gradually to avoid crushing growth.
Use forward guidance to influence expectations without excessive hikes.
Watch leading indicators (like job openings, wage growth, credit conditions) to adjust quickly.
4. Maintain Credibility
Credibility is everything: if households and firms trust the Fed to bring inflation down, inflation can ease without a deep recession.
If credibility slips, the Fed may have to hike more aggressively, risking a repeat of the early 1980s “Volcker shock.”
5. Coordinate with Fiscal Policy
The Fed alone cannot solve stagflation. Ideally:
Fiscal policy should target supply-side investment (energy, infrastructure, productivity).
Avoid large deficit spending that fuels demand-driven inflation.
✅ In short:
The Fed should prioritize breaking inflation expectations, likely through a moderately restrictive stance, while avoiding unnecessarily deep rate hikes that would worsen stagnation. Coordination with fiscal policy is crucial, since only supply-side reforms can ease the “stagnation” part without worsening inflation.