Iran War and Stagflation Risk

Context

The current dispute with Iran has caused panic of the possibility of stagflation returning to the world economy.

Key Highlights

• Stagflation is a condition of extreme inflation with low or negative economic growth.
• The ongoing crisis is of special concern since it is a price shock coupled with a supply shock in the energy markets.

Understanding Stagflation

• Iain Macleod invented the word stagflation.
• It is the worst of both worlds where:
  • Inflation rises sharply
  • There is stagnation or decrease in economic growth.
• Stagflation is historically linked to huge oil shocks.

Lessons from the 1970s Oil Crises

• The first large oil shock was the one that took place after the Yom Kippur War.
• The consequence of oil embargoes was:
  • Tangible increase in crude oil price.
  • Slowdown of the economy of the Western world.
• The second shock was brought about by the Iranian Revolution and the regional conflicts that followed.
• These incidences led to long and high inflation and growth in the world.

Recent Oil Shocks: A Comparison

• 2008 global crisis:
  • Caused to slow down economically and low inflation.
• 2022 Russia–Ukraine conflict:
  • Inflated but no deep world depression.
• 2026 Iran conflict:
  • Integrates price increase and supply shock, which increases its severity.

Process of Stagflation (Economic Explanation)

• In a normal market:
  • The equilibrium price and quantity are determined by demand and supply.
• Stagflation is caused by a negative supply shock where:
  • Leftward movement of supply curve.
  • Prices increase
  • Output declines
• This is an indication of decreased supply at each price causing a rise in prices (inflation) and a decline in production (stagnation).

Why the Current Crisis is More Severe

• The existing dispute concerns:
  • Oil supply
  • Natural gas availability
  • Petrochemical inputs
• The crisis can aggravate due to disruptions in key pathways such as the Strait of Hormuz.
• The current situation affects both unlike previous shocks:
  • Prices (costlier energy)
  • Availability (supply shortages)

Impact on India

• The economy of India is very much reliant on:
  • Imported crude oil
  • Fertilisers, such as urea and DAP.
  • LPG as household consumption.
• The disruptions in energy can result in:
  • Rising inflation
  • Industrial slowdown
  • Increased fiscal burden
• Economy is more energy consuming and is more vulnerable than it was in the 1970s.

Policy Challenges in Tackling Stagflation

• Conventional instruments are not that effective:
  • Increasing interest rates will contain the inflation but will slow further growth.
  • Hiking expenditure or reduction in taxes stimulates demand but generates inflation.
• This provides a policy quandary to the governments and central banks.

Way Forward

• Focus on supply-side solutions:
  • Diversifying energy sources
  • Strengthening supply chains
  • Increasing domestic production
  • Improve oil and gas strategic reserves.
• Encourage the process of transition to renewable energy to minimize dependence.

Conclusion

• The Iran conflict, which has been going on, has brought back the dread of stagflation as the energy prices are increased at the same time, and the supply is interrupted.
• The outcome will be determined by the amount and length of the conflict.
• Stagflation should be solved through long term structural and supply-side policies, not short term demand management.

Source: The Indian Express

Mains PYQ

(Q) Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons in support of your arguments (2019)

• Stagflation refers to an amalgamation of elevated inflation and low growth.
• Unlike other price and supply shocks, the 2026 crisis, however, is a price and supply shock.
• The fundamental cause of existing risks is energy disruptions.
• Conventional economic policies are constrained in this case.
• Supply-side reforms are essential in order to reduce the long-term effect.

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