Stagflation is back
War in Iran threatens to hit growth and confidence, deepen governments’ unpopularity and hurt public finances
Sam Fleming, Valentina Romei and Ian Smith in London and Olaf Storbeck in Frankfurt
Cristina Scocchia, chief executive of Illycaffè, the Italian coffee company, is just one of the hundreds of millions of people grappling with the price rises unleashed by the Middle East war — and the accompanying prospect of a slowing economy.
Markets stabilised this week after Donald Trump declared he had held “good and productive” talks with Iran, even though Tehran dismissed his claim.
But, for companies, households and governments across the world, the damage from the conflict is mounting, and with it the risk of stagflation — rising inflation mixed with stagnant growth.
Illycaffè, which sells its wares in 135 countries, is bracing for further rises in coffee prices — already high by historical standards — as fertiliser trade disruptions increase production costs.
Shipping delays have also worsened following the effective closure of the Strait of Hormuz, a key route for the aluminium used in the company’s red-and-silver coffee cans.
But what makes Scocchia’s predicament even worse is the impact on her customers.
The energy price surge and its impact on costs is “terrible news”, she says, “because we expect a reduction in consumer demand”.
“Inflation looked under control, but now we expect higher energy costs to hit household spending power, reducing demand, particularly for discretionary spending,” she says.
Having weathered first the fallout from the pandemic and then the energy disruption caused by Russia’s full-scale invasion of Ukraine, households and businesses are facing the third major supply shock in half a decade.
Despite market relief following initial reports about the US’s 15-point plan to end the conflict — which the Iranian leadership now says it has rejected — oil prices remain above $100 a barrel.
European and Asian natural gas costs are up more than half from prewar levels.
Such moves have forced central banks to tear up plans to ease borrowing costs.
Now they are even contemplating rate rises instead.
Economists fear the spectre of stagflation as hopes for faster growth are crushed under the weight of a new cost of living crisis at a time when politicians have little budgetary capacity to mitigate the effects on angry voters.
This is grim news for markets too.
Growth worries have dragged down global stocks.
Nor can investors look for safety in government debt, which has suffered brutal bouts of selling amid worries that inflation will prevent central banks from cutting interest rates.
Bonds fell again on Thursday as hopes over US-Iran negotiations flagged.
As the shock to inflation and growth reverberated across markets, German 10-year borrowing costs have risen above 3 per cent, touching their highest level in more than a decade, while UK yields briefly hit their highest since 2008.
“The conflict in the Middle East represents a negative supply shock with stagflationary consequences for global economies,” says Mark Dowding, chief investment officer for fixed income at RBC BlueBay Asset Management.
He warns the war could take half a percentage point off global growth and add a percentage point to inflation — and that is on his firm’s current projection for the conflict: “There are scenarios which could be much worse than this.”
The risk to growth
A combination of low growth and high inflation is a rare but unpleasant experience in developed economies, since an ailing economy normally means tepid demand and a weak labour market, dragging down price rises.
The most famous episode of stagflation occurred in the US in the 1970s, when real GDP declined for two consecutive years in the wake of the 1973-1974 oil price shock while inflation shot up to beyond 10 per cent.
Central banks face a bind in such circumstances as they need to slow down the economy even further to bring prices back under control, which is likely to destroy still more jobs in the short run.
Gauging the full economic impact of the Middle East war is nearly impossible as it is still being waged.
But if disruption persists, Paul Diggle, chief economist at investment group Aberdeen, warns that oil prices could rise as high as $180 in an extreme case, pushing the UK, the Eurozone and even the US into recession.
This could come alongside high single-digit inflation rates by late this year.
Even if this week’s efforts to de-escalate the conflict bear fruit, many warn the damage will endure.
The Strait of Hormuz, the vital transit route for much of the Middle East’s oil, will remain largely impassable until May, analysts at Oxford Economics predict.
They expect traffic to resume only slowly given the time needed to restart shuttered facilities, coupled with the continuing fear of attacks on shipping and difficulties restoring supply chains.
Mahmood Pradhan, a former IMF economist who is now a non-resident fellow at the Bruegel think-tank, says: “Even if there is a truce, a lot of damage is baked in.”
Surging energy prices have caused huge shifts in markets’ inflation expectations, particularly in the relatively short term.
Rates implied by the swap market for inflation in both the UK and euro area over the next 12 months are more than a percentage point higher since the start of the war.
Traders have jettisoned hopes for further rate cuts and are now betting that central banks, including the European Central Bank and the Bank of England, will have to tighten monetary policy to rein in price pressures.
The US Federal Reserve is also seen as more likely to raise than cut this year, according to futures markets.
Many central banks are chastened by the experience of 2021-2022, when they dismissed inflation risks as “transitory”.
Economists at the ECB, for example, are predicting that the energy crisis will have a bigger impact on inflation — which they fear could hit 6 per cent next year in the “extreme scenario” of $150 oil — than on growth.
On Wednesday, ECB president Christine Lagarde signalled rates could rise as soon as next month if there is a risk of inflation getting out of hand.
The hawkish shift has sent debt prices falling around the world.
Short-dated European government bonds, which track interest rate expectations, are set for their worst month since the bond sell-off that followed the full-scale invasion of Ukraine in 2022.
Italy’s two-year yields, which move inversely to prices, are up more than 0.8 percentage points in March, while two-year US Treasury yields have risen around 0.5 percentage points.
But damage to countries’ economic output should not be underestimated, warns Seth Carpenter, chief economist at Morgan Stanley.
“The growth side of things has got less attention than it deserves,” he says.
If oil were to rise to $110 or $120 a barrel for a sustained period of time, the BoE and ECB might increase rates but then be forced to reverse the stance as soon as next year as economies stagnate, Carpenter argues.
“The current episode should be negative for growth and boost inflation across the board.
What is the poor central bank to do?
That is the challenge.”
Many investors agree.
“The market is worried about inflation, but the risk to growth is much bigger,” says Luca Paolini, chief strategist at Pictet Asset Management.
“The starting point is worse than the 2022 energy shock,” he adds, because interest rates are higher and labour markets looser.
Populations in Asia and Europe are particularly hard hit because of their reliance on imported energy.
In the Philippines, President Ferdinand Marcos Jr has declared a “national energy emergency”, for example, while India is among the nations facing a squeeze on supplies of cooking gas.
In Europe, higher oil and gas prices are already feeding through into the real economy, squeezing household spending power and raising costs for businesses.
Motorists have been among the first to feel the pain.
Within the first three weeks of the conflict, petrol prices across the EU shot up by 12 per cent while diesel became 22 per cent more expensive, according to the European Commission’s Weekly Oil Bulletin — the second largest increase since the series began in 2005.
This is already weighing heavily on households’ morale.
A closely watched consumer sentiment index by the Commission plunged in March to the lowest level in almost three years, falling faster than in the aftermath of Trump’s “liberation day” tariffs last year.
“We do not see stagflation, but the risk is moving into the direction of stagflation,” incoming ECB vice-president Boris Vujčić told Bloomberg on Tuesday.
Business confidence has also fallen, with the S&P Global purchasing managers’ index for the Eurozone sliding to a 10-month low while companies’ costs rise at the fastest pace in three years.
The parallels with 2022 are uncomfortable.
Back then, consumer confidence in both the Eurozone and the UK fell sharply after Russia’s Ukraine invasion and failed to recover fully, leading to a prolonged period of weak household spending.
The legacy of that period is still visible.
In the final quarter of 2025, per capita consumption in the UK was still 2.6 per cent below its level in the same quarter of 2019, while levels in France and Germany had changed little.
This contrasts with a 14 per cent increase in the US.
Consumer caution is likely to persist, economists say.
Depending on the severity and duration of disruptions to global energy markets, Ruth Gregory, an economist at Capital Economics, says the Iran war could shave between 0.7 and 1 percentage points off UK consumer spending growth this year.
“Just as the economy was showing signs of improving and inflation was easing, the conflict in the Middle East has created new stagflationary pressures,” she adds.
The US is not immune
Most economists expect the US economy to remain more sheltered from the energy storm, since it is a net exporter of oil and gas.
This helps explain why the US dollar has risen over the past month against all major currencies, snapping a year-long slump.
But while the US has not experienced a surge in gas prices comparable to those in Europe and Asia, gasoline prices have risen dramatically, weighing down consumer spending and threatening Trump’s popularity ahead of the November midterm elections.
In a symbolic victory this week, the Democrats won the previously strongly Republican seat in the Florida state legislature that includes the president’s Mar-a-Lago estate after a campaign that focused on battling rising costs.
Such pressures, at such an electorally vital time, are part of the backdrop to the US president’s comments this week about negotiating with Iran, even though Tehran has to date insisted that talks have not yet taken place.
Analysts at Goldman Sachs bumped up the probability of a US recession in the coming 12 months to 30 per cent this week.
They stressed they expected quarter-point interest rate reductions in September and December by the Fed, in part because they expect unemployment to rise higher than the central bank’s own outlook.
Since the US labour market was already weakening, some economists dismiss arguments that the Fed should move towards raising interest rates.
James Hamilton, an economist at the University of California, San Diego, warned there was a risk that the Fed and Jay Powell, whose term as chair expires in May, end up “fighting the last war” by fretting too much about high inflation.
Stephen Miran, one of Trump’s appointees to the Fed board — and an arch-dove on the Federal Open Market Committee that sets interest rates — acknowledged this week that the inflation risks have risen.
But he argued that by reducing consumer spending power, the energy surge will also drag down demand and make “unemployment risks” more worrying.
Other doves on the FOMC — Christopher Waller and Mary Daly — admit it is now difficult to gauge when the US central bank will be able to cut borrowing costs, as Trump has repeatedly called for.
“With all of this uncertainty, what’s the outlook for monetary policy?” Daly asked this week.
“There is no single most-likely path.”
For politicians in the US and elsewhere, a combination of rising prices and increasing official borrowing costs is a bitter prospect so soon after the previous price spiral.
Inflation’s outsized importance in determining people’s votes was laid bare in the 2024 US presidential election, where, according to the AP VoteCast survey, those who said inflation was the most important factor were almost twice as likely to support Trump over his Democrat rival Kamala Harris.
High prices also remain at the centre of the political debate in the UK, over 18 months after discontent about the economy and inflation under the Conservative government helped Sir Keir Starmer win the 2024 election.
Starmer attempted to reboot his flailing premiership early this year by trumpeting his Labour government’s efforts to curb rises in the cost of living.
With the prospect of a renewed surge in prices, that now feels a world away.
The Bank of England is now predicting 3.5 per cent inflation in the third quarter of the year — well above its 2 per cent target.
What makes the situation particularly brittle in the UK, as well as Eurozone countries such as Italy, is the mixture of high debt burdens and borrowing costs that have risen significantly in recent years.
The debt pile-up that began during the financial crisis of the late 2000s and intensified during the pandemic has left politicians in such countries with little fiscal firepower to shelter voters from the pain of rising energy prices.
The cost of servicing those debts has already risen as investors worry over inflation, as well as whether steps taken to protect consumers could put pressure on public finance in countries still recovering from past shocks.
Reflecting such concerns, 30-year UK borrowing costs have climbed to 5.5 per cent, moving towards the 21st-century high they set last September, while Italy’s have also touched their highest level since 2023 during the war.
Such movements in the debt market have tightened financial conditions for business, adding to the drag on the economic outlook.
As the war’s consequences fan out globally, affecting everything from aluminium cans to bond yields, some analysts worry that even if a truce is reached, serious damage has already been done to the world’s economic prospects.
Kenneth Rogoff, a Harvard professor and former chief economist of the IMF, says: “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.”
Additional reporting by Claire Jones in Washington
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