Brace yourself – stagflation may be heading to the UK
A return of 1970s-style stagflation is on the cards as the Iran war drives stagnant growth and high inflation. How bad things get will depend on how long the war lasts
What is stagflation?
Stagflation is when an economy is marked by both stagnant growth and high inflation. That often means rising unemployment. In normal times, macroeconomists generally think in terms of a broad trade-off between inflation and unemployment. In recessions, with tepid demand and high levels of unused capacity, inflation tends to be low. In booms, it's the other way round: strong demand tends to push up prices.
This is the inverse growth/inflation relationship of the classic Phillips curve, one of the most fundamental concepts in macroeconomics. Stagflation breaks that logic (and indeed undermined the credibility of the Phillips curve in the 1970s). It's a highly unusual and undesirable state of affairs that leaves policymakers with no easy solutions and makes investors confused and fearful.
What happened in the 1970s?
The Arab oil embargo of 1973-1974 following the Yom Kippur war – and later, the disruption following the Iranian revolution in 1979 – sent crude oil prices sharply higher. Demand for oil is inelastic – that is, people still need to buy it even when supplies are cut and the price rises.
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And because energy is such a universal input – embedded in all aspects of economic life including transport, manufacturing and food production – those 1970s oil shocks rippled through entire economies. Costs rose, output fell and inflation surged even as unemployment climbed.
The result was a sustained period of economic malaise that conventional economics struggled to explain and policymakers to cope with. In the US, real GDP shrank for two years in a row and inflation surged to above 10%.
Why is stagflation so hard to deal with?
In such circumstances, central banks and politicians are stuck in a double-bind. If they put up interest rates to bring prices under control, they risk further slowing the economy and destroying jobs in the short run. Conversely, a policy of trying to squash unemployment and boost the economy, for example through public spending or very low interest rates, risks generating inflation and even a wage-price spiral.
In the 1970s, some central banks – notably the Bundesbank in (West) Germany – stopped inflation becoming entrenched by stepping on the brakes early and committing firmly to stable prices.
In the US, by contrast, the Federal Reserve was slower to recognise the scale of the threat, fearing the political and economic consequences of unemployment. Inflation – and, crucially, expectations of higher future inflation – became entrenched. The cost of breaking that cycle, under the leadership of Fed chairman Paul Volcker, was extreme tightening and an even more painful and prolonged recession.
Are we heading for stagflation?
It's entirely possible. “Coming on top of the ongoing Ukraine and tariff wars, the Iran war is shaping up as the biggest stagflationary shock the world has seen in five decades,” reckons Kenneth Rogoff, the former chief economist of the IMF. In the short-term, most analysts' estimates put the likely blow to the global economy at less than one percentage point and the lift to inflation in the same area. Mark Dowding of RBC BlueBay Asset Management calculates the war could take half a percentage point off global growth and add a percentage point to inflation – but that's based on current projections for the conflict: “There are scenarios which could be much worse than this”, he tells the FT.
Any reasons for optimism?
Yes. Compared with the 1970s, advanced economies are less energy-intensive, central banks are more alert to the risks of unanchored inflation and more flexible labour markets are less prone to a wage-price spiral. These factors should make it harder for a temporary shock to become entrenched, says Noah Smith on Substack. Arange of academic studies add credence to that view. Yet in truth, it is early days in assessing the likely damage from the Iran war. The oil shortage is only now about to manifest itself. As that begins to bite, things could get much worse.
Does that mean stagflation is more likely?
Recession and stagflation, yes. And even if the war ends unexpectedly quickly, a lot The future for Britain might look disturbingly like the 1970s of damage is already baked in. Even if the conflict ended now, the Strait of Hormuz would remain largely impassable for many weeks, say analysts at Oxford Economics, given the time needed to restart shuttered facilities, resecure supply chains, and the continuing fear of attacks on shipping. For Europe – and in particular the UK – the risks are acute. The continent remains heavily dependent on imported energy and its growth outlook was already fragile before the war. Britain relies significantly on imported gas and our economy has long struggled with low productivity growth and sensitivity to external shocks (Covid, Ukraine). Having only recently emerged from a period of double-digit inflation, the UK faces renewed price pressures just as growth is faltering. It's an ominous mix.
What should investors do?
Broadly, stagflationary environments tend to favour real assets over financial ones. So commodities, especially those involved in producing energy, often benefit directly from the underlying shock, and gold has historically performed well as a hedge. Stagflation is, on average, the worst kind of environment for stocks. Global stocks are already down around 9% from their late February peak (MSCI World index). But don't panic, says Duncan Lamont of Schroders. “Our analysis shows that stocks often perform well when there is stagflation, just not as well as at other times.” Based on data since 1926, the median yearly real return in a stagflation year has been about 0%. Not ideal, but “getting close to inflation in a high-inflation environment is not a bad outcome”. Defensive sectors such as utilities and consumer staples perform relatively well, as demand is less sensitive to the economic cycle. Energy and materials companies have typically done well, too.
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