Iran War and the looming prospect of Stagflation

Why in News?

The ongoing Iran war has triggered concerns of energy supply disruptions and rising oil prices, reviving the fears of stagflation. The present situation resembles the 1970s oil crisis, which pushed major economies into prolonged stagflation.

What is Stagflation?

• Stagflation is an economic condition characterised by the simultaneous occurrence of slow economic growth (stagnation), high unemployment, and high inflation. 
• Stagflation typically arises from negative supply shocks. A negative supply shock refers to an unexpected event that reduces the supply of goods and services in an economy, leading to higher prices (inflation) and lower output (stagnation). E.g., War, Pandemic, Natural disasters, closure of critical shipping routes (e.g., Strait of Hormuz) and Energy crises.

Stagflation in the Past & the factor driving it:

• During the 1970s, most Western countries experienced prolonged stagflation, driven by the oil supply shock.
  • In 1973, the OPEC (Organisation of Petroleum Exporting Countries) imposed an embargo against the US in retaliation for providing military support to Israel. As a result, global oil prices and petrochemicals skyrocketed. Higher operational costs for businesses reduced profitability and productivity while dramatically increasing the cost of goods and services. Consumer spending fell significantly, and many businesses had to downsize due to decreasing demand. The US economy entered a period of stagflation.
• The current crisis is considered more dangerous than the 2008 global financial crisis or the 2022 Russia-Ukraine shock, because it combines both:
  • Price shock (sharp rise in oil prices)
  • Supply shock (risk of disruption in the availability of oil, gas and petrochemicals)

What would be the impacts of Stagflation on the economy?

Global Impacts:

• Reduced investment
• Decline in global trade
• Currency volatility
• Stock market instability
• Rising unemployment

Impacts on India: 

India is highly vulnerable due to– High oil import dependence (~85%), LPG and other petrochemical feedstocks. High import dependence on Urea and Di-ammonium phosphate (Agriculture sector)

• Risk of non-linear outcomes in the economy (Energy crisis → sudden stoppages in industrial activity → unemployment → inflation → Financial Market Collapses)
• Inflation pressure on food prices
• Pressure on the rupee
• Increased Current Account Deficit (CAD)

What is the challenge in addressing Stagflation?

• 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. Additionally, the duration of supply shocks matters as much as their magnitude.
• Traditional policy tools are ineffective in dealing with stagflation:
  • Tightening monetary policy (increasing interest rates) to fight inflation typically slows down growth and thus increases unemployment.
  • Expansionary fiscal measures (increasing government spending and reducing taxation) to boost growth will increase demand, but as supply is constrained, it may accelerate inflation. 
• Hence, stagflationary periods like the 1970s tend to be prolonged and difficult to resolve. 

Way Forward:

• Short-Term Measures: Strategic petroleum reserves utilisation, Temporary tax cuts on fuel, Targeted subsidies for vulnerable sectors, efforts towards war de-escalation and restoring the broken supply chains. 
• Long-Term Structural Reforms: Energy transition towards renewables, reducing import dependence on fossil fuels, Domestic manufacturing push, Strategic trade partnerships and Technological innovation (AI, efficiency improvements). 

UPSC PYQ 2021

Q. With reference to Indian economy, demand-pull inflation can be caused/ increased by which of the following?

1. Expansionary policies

2. Fiscal stimulus

3. Inflation-indexing wages

4. Higher purchasing power

5. Rising interest rates

Select the correct answer using the code given below.

(a) 1, 2 and 4 only

(b) 3, 4 and 5 only

(c) 1, 2, 3 and 5 only

(d) 1, 2, 3, 4 and 5

Answer: (a) 

UPSC PYQ 2015

Q. With reference to inflation in India, which of the following statements is correct?

(a) Controlling inflation in India is the responsibility of the Government of India only

(b) The Reserve Bank of India has no role in controlling inflation

(c) Decreased money circulation helps in controlling inflation

(d) Increased money circulation helps in controlling inflation

Answer: (c) 

UPSC Mains PYQ 2024

Q. What are the causes of persistent high food inflation in India? Comment on the effectiveness of the monetary policy of RBI to control this type of inflation.