During the 1970s and early 1980s, most Western countries experienced “stagflation”— a condition where low, if not negative, economic growth coexisted with high inflation.
Thus, the United States and the United Kingdom registered annual GDP growth rates of -0.5% and -1.7% respectively in 1974 and -0.2% and -0.7% in 1975. This was accompanied by consumer price inflation of 11.1% (US) and 16% (UK) in 1974 and 9.1% (US) and 24.2% (UK) in 1975.
A similar phenomenon was recorded in 1979, 1980, 1981 and 1982, with the US alone posting GDP growth of 3.2%, -0.3%, 2.5% and -1.8% and annual consumer price inflation rates of 11.3%, 13.5%, 10.3% and 6.1% for these years.
In both episodes of stagflation — the term was coined by Iain Macleod, a British Conservative Party politician — the driver was oil shocks.
The first one came after the Yom Kippur War between Israel and Egypt-Syria in October 1973. The Organization of Arab Petroleum Exporting Countries implemented a total oil embargo against the Western nations that had supported Israel. The second oil crisis happened with Iran’s Islamic Revolution in 1979, followed by Iraq’s invasion of Iran a year later.
Since that time, the world has witnessed at least three oil shocks — in 2008, 2022 and 2026. The 2008 shock resulted in stagnation (negative to very low single-digit GDP growth), but no runaway inflation. The 2022 Russia-Ukraine war produced some inflation, but no great recession.
Will 2026 see the return of stagflation?
Before answering that, one must understand not just what stagflation is (“the worst of both worlds…inflation on the one side…stagnation on the other…together,” in Iain Macleod’s words), but also how it can occur.
In standard textbook economics, there is a supply and a demand curve, with prices (P) on the vertical and quantity (Q) on the horizontal axis. The supply curve slopes upward from left to right, depicting a positive relationship: as prices rise, producers are encouraged to increase the quantity supplied of a particular good. The demand curve, conversely, is downward sloping: Consumers buy more of a good at lower prices and less at higher rates.
The accompanying chart shows an initial supply curve (S0) and the demand curve (D0). The point where they intersect is the market-clearing equilibrium. At the equilibrium price P0, the quantity demanded by consumers Q0 matches what the producers offer to supply.
The point where demand and supply curves intersect is the market-clearing equilibrium.
Stagflation typically arises from “negative supply shocks”. Normally, any increase or decrease in the supply of a good is due to changes in its price, with other factors such as input costs, production conditions and technology remaining the same. The movement here is from one point to another on the same supply curve.
In a supply shock, the entire supply curve shifts rightward or leftward. Producers would now offer to supply more or less of a good at the same price. A positive supply shock is usually thanks to any new productivity-boosting technology (say, AI) or lower input costs, whether of energy or raw materials. The triggers for negative supply shocks are the opposite — from pandemics and natural disasters to wars and closure of vital shipping lanes (think the Strait of Hormuz). The resultant disruptions to production and trade shifts the supply curve to the left.
One can see the effect of the supply curve shifting from S0 to S1 in the chart. At the new intersection point of the supply curve S1 and D0, not only is the equilibrium price higher at P1, the quantity supplied, too, is lower at Q1.
That, in short, is stagflation.
Can that be a real possibility today?
It depends on the magnitude and duration of the supply shock.
On the magnitude, there’s no doubting the severity of the shock from the ongoing US-Israel versus Iran war. The 2022 crisis was, according to Sajjid Z Chinoy, Chief India Economist at JP Morgan, largely an oil price shock. The transmission channel was prices, with Brent crude touching a 14-year-high of $139.13 per barrel on March 7, 2022.
The present crisis is both a price and a supply shock, making it more pernicious than 2022 or 2008. It isn’t just prices, but the availability of energy itself that has become a question mark. “When gas or LPG is not available, you risk a sudden stoppage in industrial activity. These sudden stops generate non-linear outcomes in the economy. We learnt during Covid that when small businesses shut down, it’s very hard to reverse that, just as calling back workers who have left for their villages is,” Chinoy points out.
In the 1970s, Indian farmers were only beginning to use chemical fertilisers, while households overwhelmingly relied on firewood and dung cakes for cooking and a miniscule minority wore polyester and nylon fabrics.
That’s not the case today, where urea and di-ammonium phosphate have practically replaced farmyard manure, LPG cylinder coverage is near-universal, and man-made fibres are ubiquitous the way polymers are in everything from plastic bags, bottles and buckets to pipes and cables. Not for nothing the Indian economy is much more vulnerable to what is now a full-fledged energy crisis, impacting not only prices but actual availability of oil, gas and the petrochemical feedstocks and intermediates derived from them that go into a host of downstream industries.
As the second and third-order effects of the energy-related disruptions reveal themselves, they produce the pernicious and non-linear economic outcomes that Chinoy contrasts to the simple linear models, where a 1% change in input leads to a 1% change in output.
How does one deal with stagflation?
As already noted, for stagflation, the duration of supply shocks matters as much as their magnitude.
If the Iran war were to end soon — and assuming that the attacks on the West Asian oil refineries and natural gas processing facilities haven’t caused significant damage from a production restoration standpoint — the supply curve may revert from S1 to S0 quickly enough to avert a 1970s-style stagflation.
Recessions or low single-digit growth rates (like what India has faced in the past) can be addressed through expansionary fiscal (more government spending and reduced taxation) and monetary (lowering of interest rates) policies. Inflation alone can similarly be dealt with by tightening money supply and raising interest rates.
Neither of these tools works easily in stagflations. Jacking up interest rates to fix one component (inflation) may worsen the other (stagnant growth and high unemployment). Fiscal and monetary loosening to stimulate demand, when supply is constrained, will simply further fuel inflation.
Given that traditional fiscal and monetary tools are designed to manage demand, they are seen to be ineffective against stagflation, which is primarily a supply-side phenomenon. The solutions, then, would lie in repairing and restoring broken supply chains. But that’s easier said than done.
The present crisis is both a price and a supply shock, making it more pernicious than 2022 or 2008. 
The point where demand and supply curves intersect is the market-clearing equilibrium.
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