Iran War and Stagflation: Will the 2026 Crisis Trigger Global Stagflation?

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• In the 1970s and early 1980s, many Western countries faced stagflation, meaning low or negative economic growth along with high inflation. 
• For example, the US and UK had negative or very low GDP growth in 1974–75, while inflation remained very high during the same period. 
• A similar pattern was seen again between 1979 and 1982, especially in the US, with fluctuating growth and high inflation rates. 
• The main cause of stagflation was oil shocks: 
  • First: After the 1973 Yom Kippur War, when Arab countries imposed an oil embargo. 
  • Second: After the 1979 Iranian Revolution and the Iran-Iraq conflict. 
• Later oil shocks (2008, 2022, 2026) also affected economies, but: 
  • 2008 caused slow growth without high inflation. 
• 2022 led to inflation but not a major recession.

Understanding Stagflation: Causes and Mechanism

• Stagflation refers to a situation where high inflation and low or negative economic growth occur together, described as “the worst of both worlds”.
• A combination of “stagnation” and “inflation,” famously coined in the 1960s to describe a period of rising prices alongside a sluggish economy.

Basic Demand–Supply Framework

• Prices and output are determined by the interaction of demand and supply curves. 
• The equilibrium point is where quantity demanded equals quantity supplied (P0, Q0). 
• Normally, changes in supply occur due to price changes, leading to movement along the same supply curve. In contrast, a supply shock shifts the entire supply curve.
• Stagflation arises from negative supply shocks, which reduce production. 
• Causes include wars, pandemics, natural disasters, and disruptions in trade or shipping routes. These factors increase input costs and reduce supply. 

Impact on Economy

• The supply curve shifts left (from S0 to S1). 
• This leads to: 
  • Higher prices (P1) 
  • Lower output (Q1)

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Is Stagflation a Real Risk Today

• The possibility of stagflation depends on the magnitude and duration of the supply shock.
• The ongoing US-Israel vs Iran conflict has created a severe shock.
• Unlike 2022 (mainly a price shock), the current crisis is both a price and supply shock, making it more serious.
• The issue is not just high prices but also availability of energy (oil, gas, LPG).
• Shortages can lead to sudden stoppage of industrial activity and long-term economic disruptions.

Increased Economic Vulnerability

• Compared to the 1970s, India is now more dependent on energy and petrochemical products.
• Fertilisers, LPG, synthetic fibres, and plastics are widely used, increasing vulnerability to energy disruptions.
• Energy disruptions affect multiple industries through supply chains.
• These create complex, non-linear economic impacts, where small disruptions can lead to large economic consequences.

Dealing with Stagflation: Limits and Challenges

• Role of Supply Shock Duration
  • The impact of stagflation depends on how long the supply shock lasts. 
  • If disruptions end quickly, the supply curve can return to normal, avoiding prolonged stagflation.
• Limits of Conventional Policy Tools
  • Fiscal and monetary policies can address either: 
    • Low growth (through spending and lower interest rates), or 
    • Inflation (through tighter money and higher rates).
• Policy Trade-offs in Stagflation
  • Raising interest rates to control inflation can worsen growth and unemployment. 
  • Stimulating demand through spending or lower rates can increase inflation further when supply is constrained.
• Nature of the Problem
  • Stagflation is mainly a supply-side issue, while traditional policies target demand management. 
  • This makes standard tools less effective.
• Way to Address Stagflation
  • The solution lies in restoring disrupted supply chains. 
  • However, achieving this is difficult and complex.

Source: IE