New York (CNN Business)The tariff-induced market meltdown is increasing the probability that the Federal Reserve could cut interest rates later this year.
But what if the central bank goes in a different direction? There’s an argument that the Fed’s hands are tied and that it might need to actually hike rates if consumer prices creep higher. The Fed may not just be facing the risk of recession. It needs to watch out for another threat: a troublesome economic trend known as stagflation, which is when sluggish growth and inflation happen simultaneously. That’s what happened in the 1970s, when oil prices surged at the same time the broader economy was slumping.”It’s entirely possible the Fed could have to raise rates,” said Michael DePalma, managing director of fixed income with MacKay Shields, a firm that runs the High Yield (HYLD) bond ETF.”What’s tricky is that inflation is a process. It doesn’t turn on a dime. It has to work its way through,” DePalma added. “If you do get inflation it can seriously hamper the Fed’s ability to cut rates if the economy slows.”Read MoreRetailers are raising pricesMake no mistake: Tariffs imposed on China and Mexico should lead to higher prices at US retailers and car dealerships. Costco (COST) chief financial officer Richard Galanti was pretty blunt when asked about the impact of the trade war on the company’s earnings conference call Thursday evening.”At the end of the day, prices will go up on things,” Galanti said. Keep in mind that Costco is a retail powerhouse that has the financial wherewithal to absorb the hit from higher costs better than many other chains. It’s also a company that prides itself on offering bargains. So if Costco might have to raise prices, expect just about every other retailer, large and small, to do the same.China trade war: Don't bank on a rate cut unless things get really bad. Like bear market bad Lewis Alexander, chief US economist at Nomura, said in a report that he’s expecting a “pronounced impact on auto prices and some electronics” because of tariffs. He argues that food prices could go up, too. “Higher tariffs on imports from Mexico and China could provide an opportunity for price-setters to raise prices, which could make long-term inflation expectations unstable,” Alexander added. “In that case, shocks induced by tariffs might have a long-lasting impact on inflation.”Inflation risk is ‘underappreciated’A lot of people are also too quick to dismiss inflation as a concern, said Alejandra Grindal, senior international economist with Ned Davis Research.She noted that in addition to the possibility of higher consumer prices from tariffs, the healthy job market in the United States has led to higher wages. A continued rise in the size of workers’ paychecks will add to inflation pressures.”I’m not saying the Fed will definitely raise rates. But it’s a risk that’s underappreciated since tariffs and higher wages could lead to a spike in inflation,” Grindal said.The bond market is freaking out. Here's why that mattersStill, unless the pendulum swings dramatically toward a recession or a substantial pickup in inflation, the Fed may have no choice but to sit tight and wait to see how the trade war ultimately pans out.”It’s hard to see stagflation coming, but you could see consumer prices accelerate at the same time the economy slows down,” said Brian Nick, chief investment strategist with Nuveen. “That’s why I don’t think the Fed steps in either way.” The Fed also has to worry more about a prolonged economic slump because of tariffs than the risk of higher prices, said Mona Mahajan, US investment strategist and portfolio manager with Allianz Global Investors.”The case for cutting rates has escalated. There is substantial downside for the US economy,” Mahajan said, adding that the Fed may be willing to let inflation overshoot a bit in order to avoid a sharp economic slowdown.Either way, the Fed is in a bind right now. There are no easy answers about what it should do next.