Inflation may prevent the Fed from fending off a recession

Concerns over “stagflation"–a destructive combination of poor growth and rising prices that befuddle policymakers’ attempts to intervene–are dropping the floor from under stocks and sending investors to the safety of U.S. government debt, pushing down Treasury yields.

Investors worry that President Trump’s antitrade measures would keep the 12-month pace of price increases above the Federal Reserve’s 2% target while curbing economic growth. With inflation above target, the Fed would be reluctant to lower borrowing costs to jump-start the economy. Inflation and recession would coexist.

Guneet Dhingra, head of U.S. rates strategy at BNP Paribas, said stagflation risk is “one of the core themes in the market" these days. He said many of his clients believe the Fed will step in and save the day by cutting interest rates if growth stalls. “Those same investors don’t consider the fact that the Fed also has a dual mandate and has an inflation target to defend."

The rapid flow of policy changes is stoking anxiety around headline economic data, much of which still dates from January and doesn’t capture the impact of tariffs. Recently updated indicators have pointed to sticky inflation mixed with weakening activity.

Stagflation fears eased a little Wednesday after February’s annual consumer price index cooled to 2.8% from 3%, giving the Fed some room to focus on the other part of its dual mandate and ensure jobs are plentiful. The full impact of tariffs on consumer prices is yet to be felt, though, and other indicators point to a slowing economy.

The number of U.S. job openings and the rates of hires and layoffs were little changed in January, but some economists are lowering their forecast for economic growth. Earlier this week, Goldman Sachs cut its gross domestic product growth forecast for 2025 to 1.7% from 2.2%.

The challenge for the Fed is magnified by a difficult moment for fiscal policy. The House and Senate are working to hash out a budget that, in a House proposal, would cut spending by $1.5 trillion to $2 trillion. Measures that could spur growth, such as extending the 2017 tax cuts for households and corporations, are still under negotiation and could come too late to avoid a recession.

Markets are nervous. The Nasdaq Composite Index has receded more than 10% from its December high as investors worry about the business outlook. The 10-year Treasury yield, at 4.3%, is trying to recover from sharp losses in the past month amid heightened demand for low-risk assets.

Investors are betting the Fed will come to the rescue. Three or more interest-rate cuts this year are priced at 62% odds in the CME’s FedWatch tool.

“With growing concerns over stagflation, the Fed may be compelled to resume its easing cycle sooner rather than later," Nikos Tzabouras, analyst at Jefferies-owned trading platform Tradu, said in a note.

But that could be unrealistic “particularly if tariff price passthrough corners the Fed to remain on hold for longer than expected this year," said Ed Al-Hussainy, a senior analyst at Columbia Threadneedle in a recent report.

As usual, some are seeing opportunities.

“Real yields have sold off and are now bordering on cheap relative to the past two years," said Lisa Shalett, CIO at Morgan Stanley Wealth Management, in a report earlier this week. “The securities could be a potential buy in a stagflationary environment."

Write to Paulo Trevisani at paulo.trevisani@wsj.com and Matt Grossman at matt.grossman@wsj.com