The Puzzle Pieces for Stagflation Are Beginning to Take Shape, and That's Terrible News for Fed Chair Kevin Warsh and Wall Street

Despite short-lived periods of outsize volatility, it's shaping up as another stellar year for the stock market. Since early June, the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite (NASDAQINDEX: ^IXIC) have blasted to record highs.

But the good times may be nearing an end, thanks to the Federal Reserve's nightmare scenario, stagflation. While this economic scenario, characterized by high inflation, high unemployment, and stagnant or weakening economic growth, isn't currently in play, the puzzle pieces that could dramatically complicate life for Fed Chair Kevin Warsh and the Federal Open Market Committee (FOMC) are taking shape.

Fed Chair Kevin Warsh delivering remarks. Image source: Official Federal Reserve Photo.

Several traits associated with stagflation are coming together

To begin with, trailing 12-month (TTM) inflation has been tracking above the FOMC's long-term target of 2% for the last 65 months. Although headline inflation has eased from its three-year high of 4.2% in May, largely due to crude oil prices falling from their Iran war highs, it's still well above Fed Chair Warsh's and the FOMC's comfort level.

Worse yet, evidence is mounting that Trumpflation (inflation driven by President Donald Trump's policies) is becoming entrenched in the U.S. economy. The price stickiness of Core Personal Consumption Expenditures suggests it'll be challenging for the Fed to stabilize prices.

This is a bleak July jobs report:

-23,000 jobs lost in July. (Losses occurred in retail, finance, hospitality, local gov't education)
-264,000 people leave the labor force
-Wage growth falls to 3.2% = lowest in 5 years (and totally wiped out by inflation right now)
***Lowest... pic.twitter.com/F4LTwjH8yJ

-- Heather Long (@byHeatherLong) August 7, 2026

We're also seeing indications that the U.S. economy is weakening. The July jobs report featured 23,000 job losses, and wage growth of 3.2% is lagging TTM inflation. Further, annualized gross domestic product growth, as of the second quarter, is down to 1.5%.

Lastly, the unemployment rate actually fell to 4.1% in July... but there's a catch. We've observed a persistent decline in the labor participation rate, which has modestly reduced the unemployment rate even as job creation has weakened.

In several respects, the puzzle pieces for stagflation are starting to come together.

Image source: Getty Images.

Stagflation is the Federal Reserve's worst nightmare

The reason stagflation is such a frightening scenario for the Fed is that there's no ideal blueprint to combat it. Raising interest rates to stabilize prices risks further weakening the jobs market and can adversely impact economic growth. Meanwhile, lowering lending rates to boost economic growth can effectively pour gasoline on an inflation figure that's already running hot.

The lone silver lining for Warsh and his FOMC colleagues is that today's stagflation correlations look nothing like they did in the 1970s and early 1980s. The Misery Index, calculated by adding the unemployment rate and annual inflation rate, reached an all-time high of almost 22% in the summer of 1980. Today, it's less than 8%.

The US Misery Index is at a multi-year high of 8.5.

But inflation is backward-looking (of course), while the unemployment rate is a snapshot.

Using forward inflation of 2.759%, the forward Misery Index is actually just 7.06 @yardeni pic.twitter.com/U6UOCUbhEz

-- Mike Zaccardi, CFA, CMT 🍖 (@MikeZaccardi) June 13, 2026

But just because the dynamics of today's economy aren't nearly as awful as the early 1980s, it doesn't mean Warsh and his peers won't face some tough choices in upcoming FOMC meetings. The new Fed chair is trying to earn credibility with Wall Street and lower persistently high inflation, all while appeasing President Trump, who's repeatedly called for the Fed to slash interest rates.

If the job market and/or wage growth materially worsen in the coming months, and TTM inflation remains in the mid-3% range or higher, the Fed will be put on the hot seat, and a historically pricey stock market could pay the price.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.