Economists fear stagflation much the same way doctors fear a disease for which there is no effective treatment. Today, with the Middle East in turmoil once again and oil trading above $90 a barrel, this specter is once again knocking at the door of the global economy.
What Is Stagflation?
The word itself is a combination of two concepts that are terrifying for the economy: stagnation (a halt in growth) and inflation. In a normal world, these phenomena do not coexist well – classical economic theory has long considered them virtually mutually exclusive. When the economy grows, prices rise. When the economy slows down, inflation should fall. The logic is simple.
But in the 1970s, the world saw that logic can be brutally overturned by reality. After the 1973 oil embargo by Arab countries against the West, energy prices quadrupled. Production became expensive. Businesses began to scale back operations. Unemployment rose. Yet, prices did not fall – they continued to rise because energy is expensive, and it is factored into the cost of virtually everything. The term that became a nightmare for investors in the 1970s has once again made headlines on Bloomberg and Reuters.
Historical Fact
In the 1970s, inflation in the US reached 14%, while unemployment remained above 9%. It was then that economist Arthur Okun devised the “Misery Index” – the sum of inflation and unemployment. The higher the index, the worse life is for citizens. Today, analysts have dusted off this index once again.
Now, in March 2026, talk of stagflation has resurfaced with renewed intensity – and not by chance. The conflict in the Middle East, involving the United States, Israel, and Iran, has effectively closed the Strait of Hormuz to commercial shipping. About 20 million barrels of oil passed through this narrow passage between Iran and Oman every day – roughly one-fifth of the world’s total seaborne oil exports.
A disruption of global supply chains through the Strait of Hormuz is not merely a regional crisis. It is a structural blow to the global economy, delivered at a time of geo-economic fragility. And it could trigger a stagflationary scenario.
Stagflation (stagnation + inflation) is a rare and extremely painful economic condition characterized by three factors:
- Stagnation: the absence of economic growth or a slowdown in growth (a decline in GDP).
- High inflation: a rapid rise in prices for goods and services.
- High unemployment: due to business difficulties, companies are laying off employees.
Under normal circumstances, inflation is a side effect of rapid growth. People earn a lot, spend a lot, demand exceeds supply, and prices rise. However, during stagflation, prices rise not because people have a lot of money, but because of supply shocks. For example, when the cost of energy or raw materials, which are used to make everything under the sun, suddenly skyrockets.
Why Is This a Problem?
For the economy, it’s a “perfect storm.” People’s purchasing power is falling (inflation is eroding wages), and jobs are becoming scarce. For companies, it’s a double whammy: production costs are rising due to higher resource prices, while sales are falling because consumers have less money to spend.
The IMF has estimated that every 10% increase in sustained oil prices reduces global GDP by 0.1-0.2%, while adding 0.4 percentage points to global inflation. At current prices, which are roughly 30% higher than pre-war levels, the math looks daunting: about 1.2 percentage points of additional inflation, and that’s just the direct effect, without accounting for secondary ripple effects through food and industrial supply chains.
Europe finds itself in a particularly vulnerable position. The ECB has already postponed planned rate cuts and raised its inflation expectations, while simultaneously cutting its GDP growth outlook. Germany and Italy, the continent’s largest industrial economies, are on the brink of a technical recession, while chemical and steel manufacturers are imposing surcharges of up to 30% due to soaring energy prices.
A Dead End for Central Banks
Central banks typically have two tools at their disposal:
- If inflation is high, we raise interest rates to “cool down” the economy.
- If the economy is slowing down, we lower rates to stimulate business with cheap loans.
What Is The Trap of Stagflation?
If the central bank raises rates to combat inflation, it will completely “finish off” the struggling economy and trigger a deep recession. If it lowers rates to save businesses, it will fuel inflation even further by devaluing the currency.
The main problem is the lack of good options. When GDP is falling, and interest rates need to be raised, there is a risk of a systemic crisis. However, given the current levels of massive government debt (especially in the US and the EU), a sharp rise in interest rates makes servicing that debt unsustainable. This ties the hands of regulators.
The central bank cannot increase oil production, resolve geopolitical conflicts, or eliminate disruptions in supply chains. It can only influence demand, but in a stagflationary environment, the problem usually lies with supply.
So What Do Central Banks Do?
In practice, regulators have several options, none of which is ideal.
- Pause and wait. The most common response is to keep rates unchanged while observing which of the two factors proves to be stronger. This is exactly what we are seeing now: Nomura economists note that the conflict in Iran “strengthens the case for a pause for many central banks.” This is not a victory over stagflation, but it is a way to avoid exacerbating the situation with abrupt moves.
- Prioritizing inflation. Some central banks, historically, most notably the Federal Reserve under Paul Volcker in the early 1980s, chose the hard line: to curb inflation by raising rates, even at the cost of a deep recession. Volcker raised rates to 20%, which triggered a severe economic downturn but ultimately broke the back of inflation. It is painful, protracted, and politically unbearable – but it works.
- Unconventional tools. Some central banks in such situations have resorted to targeted lending, subsidizing loans for specific sectors (such as industry) to support employment without expanding the overall money supply. The effectiveness of this method is debatable.
The Main Dilemma of 2026
Former US Treasury Secretary Janet Yellen warned: “The situation in Iran is causing the Fed to be even more reluctant to cut rates.” Inflation in the US is already above the 2% target, and the Trump administration’s tariff policy is adding another layer of inflation. At the same time, consumer spending will begin to decline two to three months after the oil shock. The Fed risks finding itself in a situation where it cannot cut rates, but keeping them high is also painful.
The key challenge facing modern central banks is that they are far more effective at managing demand-driven inflation than supply-driven inflation. Raising interest rates means cooling demand. But an oil shock is a supply problem: there is physically less oil available because the strait is closed. No interest rate will reopen the Strait of Hormuz or replace the 16-20 million barrels per day that, according to IEA estimates, remain at risk even with full use of pipeline bypass routes.
How Assets Behave: A Guide for Traders
1. Risk Assets (Stocks and Indices) – Under Pressure
The US Stock Indices (S&P 500, Nasdaq): High interest rates are weighing on the tech sector. Rising production costs are eroding corporate profits. Indices are generally stagnating or falling. In a stagflation scenario, MSCI expects a 12% decline in the S&P.
European indices (DAX, CAC 40): Europe is more dependent on energy imports than the US. Amid the conflict in the Middle East, the European stock market appears extremely vulnerable. MSCI estimates that European stocks could fall by 16%.
2. Foreign Exchange Market (Forex)
The Euro (EUR) and the Pound (GBP): These currencies often find themselves at a disadvantage. The economies of Europe and the UK are more fragile, and the energy crisis is hitting them harder. If the ECB cannot raise rates aggressively due to fears of a recession, the euro will weaken. The GBP is weakening amid rising uncertainty, though less so than the EUR due to its lower dependence on industry.
US Dollar (USD): The dollar often performs well as a safe-haven currency. In addition, the Federal Reserve typically acts more decisively than other central banks. Morgan Stanley notes that the strengthening of the dollar is partially easing inflationary pressures within the United States.
Swiss franc (CHF): The Swiss franc is the second most important safe-haven asset after the dollar. Switzerland’s neutrality, robust banking sector, and low dependence on imported energy make the CHF a strong currency in any crisis. Historically, the USD/CHF and EUR/CHF exchange rates tend to decline during periods of stagflation.
3. Gold
Gold has historically been the best asset in a stagflationary environment. It protects against inflation and benefits from geopolitical uncertainty. But in 2026, since the start of the military conflict in the Middle East, gold has been on a downward trend. This suggests that large investors are choosing “cash,” which is, in fact, a very bad sign, since capital outflows from assets into “cash” typically occur only during periods of severe economic turmoil.
4. Digital Assets and Emerging Markets
Digital assets, emerging market stocks, high-yield bonds, and commodity currencies (AUD, NZD) are suffering from a flight to quality. Correlations are breaking down: what once served as diversification is no longer protecting the portfolio.
5. Energy Stocks
Energy stocks deserve special mention: they are a rare exception in a world of falling stock markets. Oil and gas companies are benefiting from rising prices for their raw materials, making stocks like Exxon, Shell, or BP relative “winners” in a stagflationary environment. That is precisely why Morgan Stanley and other banks recommend increasing positions in the defense, energy, and industrial sectors as a thematic bet on the current geopolitical reality.
Final Thoughts
Stagflation is not merely an economic problem. It is a complex crisis that simultaneously affects consumers, businesses, governments, and financial markets. Today, the risk of its return is very real, given geopolitical risks, high inflation, and the global economic slowdown.
For traders, this means one thing: a period is approaching when macroeconomics takes precedence over technical models, and diversification becomes a key risk management tool. Shift away from the currencies of countries that are most dependent on energy imports (Europe, Japan) in favor of the dollar or other safe-haven assets. Look for opportunities in safe-haven assets and energy sector stocks.
If you want to understand whether the current situation will escalate into full-blown stagflation, keep an eye on three key variables.
- The duration of the oil shock. According to analysts at the Chicago Council on Global Affairs, even if the conflict ends, delays in restoring production could keep prices high for several more months. If brent stays above $85 for more than two months, the macroeconomic impact will begin to show up in hard data.
- Central bank response. The first signs that regulators are beginning to ease policy despite inflation will signal that they have chosen “supporting the economy” as a priority, and inflation could run away with us.
- Labor market data. Rising unemployment amid persistent inflation is the official diagnosis of stagflation. As long as the US labor market remains strong, we can speak of inflationary pressure without a recessionary component. But over time, high business costs will inevitably begin to hit employment.