Are investors underestimating the risk of 1970s-style stagflation?

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The two-year Treasury yield, which closely tracks expectations for future Federal Reserve policy, has risen well above the current fed funds rate. The message from the bond market is clear: Investors appear convinced that Federal Reserve chair Kevin Warsh is prepared to lean harder against inflation following his recent hawkish remarks at the annual Jackson Hole meeting.The problem many investors are missing is that the inflation we’re seeing today isn’t being driven by excessive consumer demand, an overheated housing market or a wage-price spiral. In fact, the wage data suggest the exact opposite.Canada's best source for investing news, analysis and insight.By signing up you consent to receive the above newsletter from Postmedia Network Inc.A welcome email is on its way. If you don't see it, please check your junk folder.The next issue of Investor will soon be in your inbox.We encountered an issue signing you up. Please try againGrowth in average hourly earnings has slowed steadily from nearly six per cent in the U.S. in early 2022 to approximately 3.1 per cent as of August 2026. At the same time, real wages have turned negative again, meaning inflation is once again rising faster than paycheques. This comes after years of excessive fiscal and monetary stimulus that have significantly eroded the purchasing power of the dollar. Households are now being squeezed further by rising energy, transportation, food and housing costs.So please explain how higher borrowing costs are going to improve their situation. How exactly do higher interest rates produce more barrels of oil, more natural gas or more refined petroleum products?U.S. Treasury Secretary Scott Bessent recently highlighted this issue, arguing that the current inflation backdrop increasingly resembles a supply shock rather than a traditional demand-driven inflation cycle. Yet markets continue to price additional tightening.The problem as history suggests is that when policymakers attempt to fight supply-driven inflation with demand-destroying tools, the economy can drift toward a much uglier outcome: stagflation.For those who lived through the 1970s, it was an economic nightmare. Economic growth slowed, unemployment rose and consumer confidence deteriorated, yet inflation remained stubbornly high because energy shortages continued pushing costs upward.The origins of that crisis were relatively straightforward, and in many ways resemble the pressures we’re facing today. The 1973 OPEC oil embargo and the Iranian Revolution later in the decade sharply reduced global energy supplies. Oil prices surged, transportation costs increased, manufacturing costs climbed and food prices followed.Central banks responded with repeated rounds of monetary tightening that compounded the economic damage already being inflicted by the supply shock. At least at the time there was a rationale. Wage growth accelerated, labour unions had greater bargaining power and policymakers were increasingly concerned about a wage-price spiral becoming embedded in the economy.This advertisement has not loaded yet.This advertisement has not loaded yet, but your article continues below.Today, the situation is very different.Wage growth is slowing, not accelerating. Labour markets are more flexible, inflation expectations remain better anchored and workers are largely absorbing higher prices rather than successfully passing them on through higher wages. If wages are not driving inflation, investors should be asking a simple question: Why is the market so convinced that higher interest rates will solve it?The bond market itself appears to be warning that all is not well. Yet many economists and market commentators somehow believe this round of rate hikes will be different and will magically push bond yields lower. That argument makes little sense. If supply constraints remain the primary driver of inflation, tighter monetary policy risks weakening growth without solving the underlying problem. Unfortunately, there is no monetary solution to an energy shortage.The real solution lies in increasing production, expanding infrastructure, encouraging investment and removing barriers to supply growth. Ending the conflict with Iran and reopening the Strait of Hormuz would likely do far more to reduce inflationary pressures than another quarter-point rate hike. This, in addition to ending the costly trade wars being imposed upon its trading partners such as Mexico and Canada. But these are levers controlled by the White House, not the Federal Reserve.For investors, that distinction matters enormously.The 1970s should serve as a warning as to what is to come. Bond investors were hit hard by rising yields and inflation-eroded real returns, while equity investors faced weaker growth, margin pressure and valuation compression. The S&P 500 lost roughly 50 per cent of its value during the 1973-74 bear market, and real equity returns remained disappointing for much of the decade.I am still waiting for someone to explain to me why tighter monetary policy can suddenly succeed where it could not address the underlying problem decades ago?With this as context, I think the greatest risk next week may not be that the Federal Reserve does too little but that it does exactly what the market expects.Martin Pelletier, CFA, is the author of Investing Through the Storm and a senior portfolio manager at TriVest Wealth, a team that is part of Wellington-Altus Private Counsel Inc. TriVest provides discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus._____________________________________________________________If you like this story, sign up for the FP Investor Newsletter.Notice for the Postmedia NetworkThis website uses cookies to personalize your content (including ads), and allows us to analyze our traffic. Read more about cookies here. By continuing to use our site, you agree to our Terms of Use and Privacy Policy.