The nightmare of stagflation looms under the dual pressures of recession and inflation, and the Federal Reserve may face difficult choices

According to the Zhitong Finance APP, the weak performance of the U.S. non-farm payroll data in August has raised concerns about an economic recession. For the Federal Reserve, the U.S. Consumer Price Index (CPI) for August, to be released this week, may trigger worries about a more frightening scenario of stagflation.

Earlier this year, the market was concerned about inflation issues, while the job market appeared relatively healthy. However, everything took a sharp turn after the release of the U.S. non-farm payroll report for July— the number of new jobs added in July fell far short of expectations, and the figures for May and June were significantly revised down. The non-farm payroll data for August, released last Friday, confirmed the trend of weakness in the job market.

Nightmare Scenario

Now, the Federal Reserve seems to be facing a nightmarish situation, having to decide which aspect of its dual mandate should take priority. The market believes that the Federal Reserve will prioritize the labor market. Market pricing shows a 92% probability that the Federal Reserve will cut interest rates by 25 basis points at its next meeting, with an 8% probability of a 50 basis point cut. It appears that even if inflation rises significantly in the coming months, the inflation issue may be temporarily placed in a secondary position.

The U.S. CPI data for August itself is not particularly threatening; the key lies in the foundation it lays for subsequent developments. Analysts expect the overall CPI to rise by 0.3% month-on-month in August, up from 0.2% in July; and to increase by 2.9% year-on-year, up from 2.7% in July. Meanwhile, the core CPI is expected to rise by 0.3% month-on-month and by 3.1% year-on-year, unchanged from July.

The swap market aligns with analysts' predictions, also anticipating a 0.3% month-on-month increase and a 2.9% year-on-year increase in the August CPI. However, after August, the swap market predicts that inflation will accelerate to 3.4% by May 2026. While this is far from the terrifying inflation levels seen in 2022, it is undoubtedly moving in the wrong direction.

For the Federal Reserve, this is already a sufficiently tricky issue. If it cuts interest rates, it may fuel inflation, essentially gambling on whether the inflation caused by tariffs is truly "transitory."

Not Just Tariffs

The ISM Services Price Index indicates that the potential risks of inflation seem to primarily stem from service sector inflation rather than goods inflation. Comparing the ISM Services Index with the year-on-year CPI, it can be observed that the ISM Services Index typically leads the CPI by about three months.

Of course, many regional Federal Reserve surveys indicate that inflation remains an issue in the manufacturing sector. Since the end of 2024, these indices have also been steadily rising, suggesting that the Producer Price Index (PPI) may also increase

Therefore, the Federal Reserve faces a dilemma: either cut interest rates to prevent further deterioration of the labor market or maintain rates to ensure that inflation is indeed temporary. Of course, this is a nightmare scenario, as the Federal Reserve cannot both cut rates and keep them unchanged.

This is a tough choice, but one thing is clear: if the CPI and PPI are announced as expected this week, it will confirm the market's inflation forecast direction. And this direction—whether liked or not—combined with the already issued recession warnings from a weak labor market, is most likely to result in stagflation. This would be the Federal Reserve's worst nightmare