The Fed could be blindsided by 'stagflation'

Most Central Bank watchers know that our Federal Reserve has a dual mandate of stable prices in the context of maximum unemployment. But its use of the words "stable and maximum" is somewhat misleading. For instance, one would assume that "stable" inflation would lead the Fed to pursue no change in prices and "maximum" unemployment would be a rate targeted at 0 percent; but this is not the case.

For some antithetical economic reason central bankers have unanimously redefined stable prices as adopting a 2 percent inflation target. The Fed has also morphed the term maximum unemployment rate to mean 5-6 percent, clinging to the misguided belief that full employment is the progenitor of inflation, despite no supporting economic or historical evidence.

What the Fed doesn't understand is that full employment can exist in perfect harmony with stable prices. That's because having more people producing goods and services can never by itself lead to an environment of rising aggregate prices. And, most important, an increasing rate of inflation increases the rate of unemployment.

This condition plagued the United States during the majority of the 1970's and early 1980's and was "affectionately" referred to as stagflation: rising inflation that is coupled with a high unemployment rate and low to negative economic growth.

But Janet Yellen isn't going to have to dust off her eight track of KC and the Sunshine Band to evoke the 1970's; she is creating 70's style stagflation with her monetary policies.

For the past few weeks the Fed has been circling the wagons trying to convince markets it can raise the Fed funds rate slow enough to boost GDP growth higher than the 0.5 percent rate in the first quarter; while also raising it quickly enough to prevent inflation from getting out of control.

But, as evidenced in the following two charts below, you can plainly see that since July of 2015 economic growth has been languishing, while CPI has been rising during a relatively similar time span.

In fact, the most recent month over month increase in the CPI of 0.4 percent was the highest since February 2013.

Meanwhile, the unemployment rate, which conveniently excludes discouraged workers, appears benign at just 5 percent. But we are starting to see chinks in the armor of employment.

Most recently, the 4-week moving average for unemployment claims was 275,750, an increase of 7,500 from the previous week's unrevised average of 268,250. And according to the BLS, the economy added just 160,000 new jobs in April. Wall Street had expected a 203,000 gain. This left many to wonder if hiring has begun to taper off along with a broader economic slowdown.

According to Market Watch, the pace of hiring was the lowest since September 2015 and job creation has slowed to an average of 200,000 net new jobs created for the past three months. This slowdown in the pace of hiring is coming off a five-year high of 282,000 a month in the fourth quarter of last year.

As stated before the Fed is seeking robust growth in the context of low inflation. But what is becoming manifest is the exact opposite. The Fed is missing its targets on both fronts--inflation is rising while at the same time growth is slowing.

What will Janet Yellen do if faced with a recession that comes along with inflation? Both the Fed and Wall Street are totally unprepared for this risk.

The government's effort to engender viable growth through debt and inflation is virtually guaranteed to fail. It has tried to repair an asset bubble and debt saturated economy by increasing both conditions. But, the real medicine the economy needs is to allow the free market to set interest rates much higher, which would deleverage the economy and allow the normalization of asset prices to income ratios.

This is why a collapse worse than 2008 is inevitable.

After 90 months of ZIRP and the creation of unprecedented asset bubbles—especially in the fixed income area—a neutral level on the Fed Funds Rate does not exist. Bubbles never pop with impunity no matter how much the FOMC would like investors to believe this time is different.

The Fed will either be slowly raising interest rates into an economic meltdown or will remain behind the inflation curve until inflation runs intractable. Therefore, the most salient question for investors to answer is: Will the economy suffer through a 70's-style stagflation before the markets and economy fall into a steep and unprecedented contraction, or will it simply implode into the inevitable deflationary collapse straight away.

Commentary by Michael Pento who produces the weekly podcast "The Mid-week Reality Check,"is the president and founder of Pento Portfolio Strategies and author of thebook "TheComing Bond Market Collapse."

Follow CNBC's Opinion section on Twitter @CNBCopinion.

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