Iran war revives the risk of stagflation 50 years after the last major crisis

The risk of stagflation, that dreaded word, is back, 50 years after one of those episodes that seem unnatural. The combination of high inflation and low or zero growth—that is, sharply rising costs amidst a sluggish economy—is one of those rare scenarios in developed countries that only a significant external shock can trigger. Weak consumption and investment usually tend to cool wages and costs, but when these rise for an extended period due to an exogenous factor that defies the law of supply and demand—for example, a war like the one in Iran—they can ultimately stagnate economic activity, and this standstill will also fail to curb inflation.

One has to go back to the oil crisis of the 1970s to find an example of this, but warnings have been mounting in recent days, especially in Europe, as the conflict enters its first month. “It is clear that we are facing a risk of a stagflation crisis,” warned the European Union’s Economy Commissioner Valdis Dombrovskis last week. Croatian Governor Boris Vujcic, who will assume the vice-presidency of the European Central Bank (ECB) in May, summed it up in a recent interview with Bloomberg: “We don’t see stagflation, but we are moving in that direction; how far we will go is very difficult to predict.”

The outlook could not be more uncertain, or more volatile. Donald Trump’s promise this week of an imminent end to the war, “in two or three weeks,” boosted stock markets on Wednesday and stabilized the price of oil at $100. However, in the early hours of the morning in Europe, the U.S. president addressed the nation, reiterating his commitment to ending the conflict but stating that Iran would first be struck “extremely hard,” which sent markets reeling once again.

Neither Brussels nor Frankfurt wants to downplay the current risks after having underestimated, in its initial stages, the inflationary crisis of 2021 and 2022 stemming from supply chain disruptions and soaring energy prices following Russia’s invasion of Ukraine. In its central scenario, the ECB projects inflation will reach 2.6% this year in the eurozone, with GDP growth of 1.9%, but in its most severe scenario, price increases could exceed 6% by 2027, well beyond the 2% target.

Everything, or almost everything, depends on the duration of the conflict. “If it escalates,” warns Joaquín Maudos, a professor at the University of Valencia in Spain, “stagflation, further interest rate hikes, increased loan defaults, and so on are anticipated. In fact, the rise in the Euribor [the benchmark interest rate with which banks lend or borrow from one another] is already pricing in this scenario, anticipating the ECB’s reaction in its future decisions.” ECB President Christine Lagarde has stated that the central bank is ready to raise interest rates—that is, increase the cost of borrowing in order to curb inflation.

Economist Manuel Alejandro Hidalgo distances himself from the more alarmist positions. A case of stagflation, he notes, “requires more than just an energy shock; it requires other forces to intervene, for that price spiral to continue and take on a life of its own.” This is what Lagarde termed last week “tit-for-tat inflation.” In other words, social actors demanding corresponding wage increases to avoid losing purchasing power, thus fueling inflation.

“That’s what happened in the seventies, although it built on an already inflationary sixties, but it didn’t happen with the Ukrainian energy shock; there was a containment effort. That energy shock was acute, but temporary,” Hidalgo points out. “To talk about stagflation, we need a prolonged episode that takes on a life of its own; otherwise, this remains a supply shock.”

The most significant period of stagflation on record dates back to the oil crisis half a century ago. Between 1973 and 1975, the United States experienced its most severe economic contraction since World War II. According to data from the Brookings Institution, real GDP plummeted by 7% in the first quarter of 1975, compared to the peak in 1973, while inflation remained above 10%.

Back then, the embargo imposed by oil producers on Israel’s allies, in retaliation for the Yom Kippur War, quadrupled the price of a barrel of crude. The current increase is less than 50% since the conflict began. More recently, the abrupt cut in Russian supply, stemming from the conflict in Ukraine, tripled prices compared to what they were at the end of 2020. Furthermore, in terms of inflation, the economy is in better shape than when Russia launched its invasion, when prices were rising at a rate of 5%.

But an oil shock, if prolonged, ends up hindering growth to the point of stagnating an economy or pushing it into recession. The rising cost of crude oil and natural gas spreads like wildfire to the so-called real economy, which reflects families’ ability to spend and companies’ capacity to invest. Products become more expensive due to the increased cost of production and transportation, consumption suffers due to the loss of purchasing power, and this impacts businesses, which slow job creation or may even consider reducing their workforce.

The effects are already being felt. For Spain, the OECD is already forecasting average inflation of 3% this year, and this doesn’t seem far-fetched: in March it climbed to 3.3%, one percentage point higher than a year ago, due to rising fuel prices. And in the same month, consumer confidence in the eurozone fell by 1.6 points (to 96.6), while employment expectations dropped by 1.4 points, also to 96.4. This, combined with the decline already experienced in February, moves both indicators further away from the 100 average they have maintained for some time.

Another cause for concern is that this new stress test for the global economy comes after several crises and amid a wave of tariffs, which is itself potentially inflationary. Former Spanish Secretary of State for Trade Marisa Poncela warns that, a year after the announcements, “international trade is disrupted” and the current conflict “affects a key node of this trade,” alluding to the blockade of the Strait of Hormuz, through which a quarter of the world’s oil and liquefied natural gas passed before the war began. The ECB, once again, will have to choose between a scare and a disaster in dealing with this.

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