Wall Street can't shake a nightmare about the US economy. 

The nightmare is not that the country goes into a recession because of the Federal Reserve's attempts to wrangle inflation — it's much worse than that.

The latest night terrors came on Tuesday, when the Bureau of Labor Statistics said the consumer price index rose by 0.1% from July to August and by 8.3% compared with the year before — above analysts' predictions of a 0.1% monthly drop and 8.1% annual growth. 

Under the hood things were ugly too: While gas prices fell, grocery costs were up by 13.5% in the past year — the largest increase since 1979 — and the cost of health insurance was up by 24.3%, the largest increase in US history.

This disappointing report means Wall Street's nightmare scenario for the economy is still in play. In this scenario, there is no hard landing or soft landing for the economy; we just get stuck. Inflation comes down a bit from its scalding-hot level but stays persistently higher. The Federal Reserve — for reasons ranging from a fragile job market to the government's debt — can't aggressively shake higher prices out of the system. And Americans end up with both uncomfortably high interest rates on things like mortgages and credit cards and higher prices, which continue to eat up wages and destabilize prices.

Basically, the economy sucks.

Soft, hard, and neutral

The Fed's goal right now is to get the economy back to a "neutral" state where growth is steady, the job market is holding up, and inflation is high enough to help stoke growth but not so high that we have price instability. In a healthy US economy, the Fed's inflation goal is 2% year over year.

Since the 2008 financial crisis, the Fed's biggest problem has been that inflation is too low. So it kept interest rates at 0% to spur financial activity and growth. Then the COVID-19 pandemic hit, supply and demand were thrown out of whack, and, eventually, inflation surged through the economy as it reopened.

When inflation starts creeping up, central banks like the Fed hike interest rates to make it more expensive to borrow cash. This slows the flow of money through the economy, and, in theory, slows price growth. But in this case, prices didn't creep up — they surged, and the Fed was caught on its back foot. 

Wall Street constantly harps on the Fed for acting too late to keep up with inflation — for not hiking rates fast enough. But I'm not here to delve into hypotheticals about past policy. In the world of financial markets, that's how you go from polite country-club conversation to something like an argument in Elon Musk's Twitter mentions in no time flat.

But we can all accept that the Fed has a serious problem on its hands now. Chairman Jerome Powell and his band have been raising interest rates fairly quickly, but the main Fed interest rate is still just 2.5%. That's not enough to rid us of 8% inflation, much less get us back to the Fed's goal of 2%. That is why the Fed says rates will continue to go up.

The difference between a hard landing and a soft landing for the economy is in how this gap is closed. In a soft-landing scenario, supply catches up with demand, prices cool, and inflation numbers come down to meet interest rates without the Fed having to cause too much pain for the job market or push us into a recession. In a hard-landing scenario, the Fed hikes interest rates up to meet inflation, which in turn slows the economy, causes the unemployment rate to surge, and crashes us into a recession. 

But there is a third option, one in which the pain we're experiencing dulls, but never fully goes away.

A long way to go

This is where Wall Street's nightmare scenario comes in. It's not a hard or a soft landing. It's not a landing at all. 

Earlier in the year, the surge in prices was mostly coming from categories affected by outside forces, like gas prices and used cars, which were pushed up because of Russia's invasion of Ukraine and the pandemic, respectively. But as the months roll by, these price pressures are easing. Inflation is starting to come from "stickier" categories: apartment rents, healthcare, and services. That seriously increases the chance that, instead of working itself out, inflation will stick with us for a long, long time.

The worst case is an economy where interest rates and inflation never meet. It's a limbo of stubbornly high inflation and higher interest rates. The Fed continues to hike rates but never does so in a way that truly tames inflation. Price growth sticks around 4% or 5%, well above the Fed's target. Businesses are stuck with rapidly rising input and labor costs, higher borrowing costs, and major uncertainty about economic growth. It's also terrible for employment and American households. Jason Furman, who was a White House economist during the Obama administration, said after the CPI report came out that while it's not his most plausible case, this nightmare scenario with inflation staying above 4% and the unemployment rate rising above 6% is still on the table.

David Einhorn, the founder of the hedge fund Greenlight Capital, also talked about this disaster scenario at the Sohn Investment Conference in June. He said that at 8% inflation, the Fed would have to hike interest rates up to 7% to achieve neutrality.

"The idea that tightening a percent or two from here will beat inflation is hardly credible," he said. Einhorn argued that the Fed needed to hike more dramatically — to give the economy a massive hike as Paul Volcker did as chairman in the 1980s. But Einhorn added a worrying wrinkle to this scenario: that the Fed would be stopped in its tracks by what high interest rates would do to the US Treasury.

"Powell faces a problem that Volcker didn't have," Einhorn said. "We have $24 trillion in debt held by the public, which is up over six times in the last 20 years. Approximately $7 trillion has to be rolled in the next year. Every 1% increase in the rates adds $70 billion to the deficit, so raising rates to 4% would add $280 billion, 8% would be $560 billion, and a full Volcker — 19% — would be $1.3 trillion. And that's just the first year."

Faced with all that, the Fed will have to blink and stop raising rates, leaving us with persistently high inflation and economy-dragging interest rates. And Einhorn isn't the only one who thinks Fed policy is constrained in this way. In August, Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed published a paper arguing that a lack of constraint in fiscal spending was also pushing inflation higher psychologically. Since no one in Washington can stop spending, the market doesn't believe that economic conditions will really tighten. If the market is to believe we're serious about inflation, they argue, we have to tighten our fiscal policies.

If Einhorn, Bianchi, and Melosi are right, we could be in economic limbo of stubbornly high inflation and higher interest rates for a while.

None of these scenarios — good, bad, or ugly — is certain. The Fed has been raising interest rates for only a few months, and we don't have enough inflation data to know if its policy alone will be enough to bring us back to neutral. Analysts at JPMorgan think think a soft landing is still within our reach. The US is still creating jobs at a steady clip, and the consumer is still going strong. China's economic slowdown is pushing commodity prices lower. We can dare to hope that the Ukrainians will continue to push Russian forces out of their territory, which would help stabilize food prices too. All is not lost.

Einhorn acknowledged that his theory could be wrong, but the Fed can be wrong too. It's possible that the Fed's failure to raise rates earlier in the pandemic will lead it to hike rates dramatically next year, pushing our economy into a recession. Or maybe it will all work itself out without too much economic pain.

But there is also the terrible, miserable third path in which we can't beat inflation at all. We should hope to avoid it at all costs.

Linette Lopez is a senior correspondent at Insider.