Throughout the 1970s and early 1980s, many Western nations grappled with a challenging economic scenario known as “stagflation.” This term refers to a troubling period characterized by stagnant economic growth alongside rising inflation rates.
In 1974, the United States and the United Kingdom recorded GDP growth rates of -0.5% and -1.7% respectively, followed by -0.2% and -0.7% in 1975. During the same years, inflation surged, with consumer prices increasing by 11.1% in the US and 16% in the UK in 1974, and 9.1% in the US and 24.2% in the UK in 1975.
This trend continued into 1979, 1980, 1981, and 1982, with the US reporting GDP growth rates of 3.2%, -0.3%, 2.5%, and -1.8%, alongside annual inflation rates of 11.3%, 13.5%, 10.3%, and 6.1% in those respective years.
The concept of stagflation, first introduced by British Conservative politician Iain Macleod, was largely influenced by sudden increases in oil prices.
The initial oil crisis was triggered by the Yom Kippur War in October 1973, during which the Organization of Arab Petroleum Exporting Countries enforced a comprehensive oil embargo on nations supporting Israel. A subsequent crisis occurred following Iran’s Islamic Revolution in 1979, compounded by Iraq’s invasion of Iran in 1980.
Since then, the world has experienced multiple oil shocks, notably in 2008, 2022, and projections for 2026. The 2008 shock led to economic stagnation without significant inflation, while the 2022 conflict between Russia and Ukraine caused some inflation but did not result in a major recession.
As we look ahead to 2026, questions arise about the potential for a return to stagflation.
To assess this, it is essential to grasp the nature of stagflation—described by Macleod as “the worst of both worlds,” where inflation and stagnation coexist—and the mechanisms that lead to its occurrence.
In traditional economic theory, the dynamics of supply and demand are illustrated through curves representing price (P) and quantity (Q). The supply curve typically ascends from left to right, indicating that higher prices incentivize producers to increase supply. Conversely, the demand curve slopes downward, showing that consumers purchase more at lower prices and less as prices rise.
The initial interaction between the supply curve (S0) and the demand curve (D0) establishes a market equilibrium. Here, at the equilibrium price (P0), the quantity demanded (Q0) aligns with the quantity supplied.
Stagflation often results from “negative supply shocks,” which deviate from the typical supply and demand interactions. Generally, variations in supply are linked to price changes, with other variables, such as production conditions and input costs, remaining stable. However, a supply shock alters the entire supply curve, either increasing or decreasing the quantity available at given prices.
A positive supply shock may arise from advancements in productivity or reduced input costs, while negative shocks can result from pandemics, natural disasters, conflicts, or the disruption of critical trade routes. Such disruptions shift the supply curve leftward, leading to increased prices and lower quantities supplied.
As illustrated, when the supply curve shifts from S0 to S1, the new equilibrium reflects a higher price (P1) and reduced quantity (Q1), encapsulating the essence of stagflation.
The likelihood of experiencing stagflation today hinges on the scale and duration of the current supply shock.
The ongoing conflict involving the US, Israel, and Iran highlights the seriousness of the current situation. The 2022 crisis was primarily an oil price shock, with Brent crude reaching a peak of $139.13 per barrel on March 7, 2022. Presently, the crisis manifests both as a price and supply shock, posing greater challenges than the previous instances in 2022 and 2008. The availability of energy resources, not just their cost, is now at risk. Sajjid Z Chinoy, Chief India Economist at JP Morgan, emphasizes that shortages of gas or LPG could lead to sudden halts in industrial operations, resulting in significant and unpredictable economic consequences.
In the 1970s, Indian agriculture was just beginning to adopt chemical fertilizers, while traditional cooking methods relied heavily on firewood and dung. Today, the agricultural landscape has changed dramatically, with modern fertilizers and LPG widely used, making the economy more susceptible to the ongoing energy crisis. This crisis threatens not only price stability but also the availability of essential resources, which are crucial for various downstream industries.
As the secondary and tertiary effects of the energy disruptions unfold, they may lead to complex and non-linear economic outcomes that differ from straightforward economic models, where a 1% input change results in a 1% output change.
Addressing stagflation requires careful consideration of both the duration and intensity of supply shocks.
If the conflict in Iran were to de-escalate quickly, and if the damage to oil refineries and natural gas facilities were minimal, there could be a rapid return to previous supply levels, potentially averting a scenario reminiscent of the 1970s.
