West Asia war: Does the growing risk of stagflation narrow India’s policy space?

The Monetary Policy Committee (MPC) meeting of April 6-8 conveyed a clear message that the problem is no longer demand, it is supply. By disrupting supply chains, the Iran war has added a new layer of uncertainty to the economy. 

This is where policy space narrows: raising interest rates may slow economic growth, cutting rates risks increasing inflation, and doing nothing allows both pressures to intensify. The signs are already visible: costs are rising, output is under strain, and the government is stepping in to cushion key sectors even as inflation and growth move in opposite directions. 

This indicates the emergence of not a sudden shock, but the return of stagflation as a constraint on policy. Marked by an economic condition of rising prices and slowing growth, stagflation largely put India’s conventional fiscal and monetary tools under strain. 

Demand management as the core of macroeconomic policy

Modern macroeconomic policy has largely been built around demand management. This follows the Keynesian tradition in which changes in aggregate demand are seen as driving fluctuations in output. Monetary policy – aims at maintaining price stability, which is a necessary precondition to sustainable growth – primarily works through interest rates. 

When inflation rises due to excess demand, the central bank raises rates. This makes borrowing costlier, slows down spending, and moderates inflation. Conversely, when growth weakens, the central bank cuts rates. This makes credit cheaper and encourages investment and consumption. 

Fiscal policy – how the government manages taxes, spending, and borrowing to meet economic goals – follows a similar logic. Government spending, tax cuts and transfers are used to support demand. During downturns, expansionary fiscal policy raises incomes and boosts consumption. These tools are effective when the problem lies in demand. If the economy overheats, demand is cooled. If it slows, demand is stimulated. 

But this logic breaks down when shocks come from the supply side. Economists, from Milton Friedman to Robert Lucas, argued that inflation can arise not only from excess demand, but also from cost pressures and expectations. Supply disruptions, such as energy shocks, raise prices while reducing output. In such cases, tightening demand may help control inflation, but at the cost of a deeper economic slowdown.

When supply shocks drive inflation and slow growth

Stagflation is primarily driven by disruptions in production rather than excess demand. The current global scenario is reflective of this condition. Energy supply disruptions have raised costs across sectors – transport, manufacturing, and agriculture all face higher input prices. 

Firms pass these costs on to consumers, pushing inflation higher. At the same time, higher costs reduce output: production slows down, investment weakens, and growth declines. This is not a demand problem. It is a cost-driven, supply-side problem. 

The roots of this understanding are usually traced to the stagflation of the 1970s. Economists, such as Arthur Laffer and Robert Mundell, argued that policies must focus on incentives to produce – tax structures, regulation, and energy costs – rather than rely on managing demand. The West Asia crisis shows how global shocks are being transmitted through supply constraints, affecting both inflation and growth in India. 

The policy dilemma 

During the condition of stagflation, policy faces a trade-off. If the central bank raises interest rates to control inflation, it slows growth further. Higher rates dampen investment and consumption, deepening the slowdown. 

The latest MPC assessment makes this tension explicit. The West Asia crisis is transmitting into the Indian economy through multiple channels. Higher crude oil prices are pushing up imported inflation and widening the current account deficit. Disruptions in the supply of energy, fertilisers, and key commodities are affecting industries, agriculture, and services, thereby reducing output. 

At the same time, uncertainty and risk aversion are tightening financial conditions, affecting consumption and investment. External demand is also expected to weaken, while global financial volatility may raise borrowing costs. The RBI has acknowledged that the economy is facing a supply shock and has apparently adopted a ‘wait and watch’ approach. 

Monetary policy is most effective when inflation is demand driven, and less effective when it is driven by supply shocks. Raising interest rates does not increase the supply of oil, resolve supply chain disruption, or reduce import dependence. This is where the dilemma sharpens: a policy designed to manage demand is expected to address a problem it cannot directly fix. 

From short-term measures to structural reform

The immediate focus is on managing the shock. This means limiting the pass-through of fuel prices where possible, ensuring the availability of critical inputs, and keeping supply chains functional. 

But short-term cushioning is not sufficient. The deeper response needs to be structural. India’s dependence on imported energy remains a core vulnerability. Diversifying energy sources, scaling up renewables, and reducing reliance on imported fossil fuels are no longer long-term goals. They are macroeconomic necessities. 

At the same time, strengthening domestic manufacturing and logistics systems becomes central to reducing cost pressures during external shocks. 

Rethinking inflation targeting in a changing world

In such situations, the RBI can influence the cost of money, the availability of credit, the pace of currency adjustment, and the trajectory of inflation expectations. In other words, monetary policy can treat the symptoms, while cure lies elsewhere. 

Moreover, inflation targeting was designed for a relatively stable, demand driven world. That assumption no longer holds. Repeated shocks – pandemics, war, and energy disruptions – have made supply constraints central to macroeconomic outcomes. 

The need to recognise this shift cannot be overlooked. The existing policy framework requires greater flexibility to account for supply shocks by allowing policymakers to look through temporary cost pressures while preventing them from becoming entrenched in expectations. 

Post read questions

What is stagflation? Why are traditional monetary policy tools less effective in addressing it?

The current global inflationary pressures are largely supply-driven rather than demand-driven. Examine in the context of the ongoing Iran conflict.

Explain how geopolitical conflicts in West Asia transmit economic shocks to India.

Distinguish between demand-pull inflation and cost-push inflation with suitable examples.

The Iran war represents a classic negative supply shock for the global economy. Discuss its implications for India’s growth and inflation.

(Pushpendra Singh is an Assistant Professor of Economics at Somaiya Vidyavihar University, Mumbai, and Archana Singh is an Assistant Professor of Gender and Economics at the International Institute for Population Sciences, Mumbai.) 

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