Economics of Iran crisis threatens a political backlash

There has been a significant anti-incumbency trend across much of the world in recent years. Although elections like Brazil’s presidential ballot last month show this is far from being an iron law of politics, the backlash against established governments and politicians may yet grow.

This is not least down to the specter of stagflation being increasingly on the radar screen of many policymakers. To be sure, this prospect is still quite widely dismissed as a serious possibility by many market participants, but there are substantive reasons why the mood music of economic debate is becoming more negative.

Stagflation is often defined as a multiyear period of economic malaise, with poor economic growth, high unemployment and persistent inflation. Australian Reserve Bank Deputy Governor Andrew Hauser said, soon after the Iran crisis began earlier this year, that this combination is a “central banker’s nightmare.”

Data does not yet indicate that stagflation currently grips the world economy. Many financial market participants remain heavily bought into a powerful opposing narrative of an unprecedented capital expenditure boom into artificial intelligence technologies, fueling stock market surges.

There are substantive reasons why the mood music of economic debate is becoming more negative
Andrew Hammond

In the US, the so-called misery index, calculated by adding the unemployment rate and annual inflation rate, is at a multiyear high of about 8 percent. Yet this is still much less than the almost 22 percent reached in the summer of 1980. Indeed, real US gross domestic product has not registered a negative quarter since early 2025, even though there are some signs of decelerating growth amid higher borrowing and energy costs.

Yet, while the fundamentals of today’s US and much of the wider international economy are not nearly as bad as they were for much of the 1970s and early 1980s, governments are still facing increasingly challenging choices. The number of red lights flashing is increasing, including a lack of optimism that there will be any sustainable breakthrough in the Iran crisis any time soon.

This is added to by hawkish commentary from some central banks after recent interest rate rises. Traders are now anticipating at least two more increases by the US Federal Reserve and several more by the European Central Bank in the coming months. Plus, there is investor nervousness about the indebtedness of a growing number of governments, alongside future fiscal plans, pushing up bond yields.

Many perceive stagflation as a phenomenon last experienced a generation ago following another big energy shock emanating from the Middle East. However, while that was indeed the classic period of stagflation, there was a more recent period when it threatened to rear its head, showing that its threat has not necessarily disappeared forever.

After the US subprime crisis began, the period from about 2006 to 2012 (sometimes called the great financial crash and its aftermath) saw weak average annual GDP growth of 1.1 percent and comparatively high unemployment of 7.3 percent. Moreover, while consumer price index inflation was relatively quiescent at some 2.2 percent, the quantitative easing utilized by Ben Bernanke, Federal Reserve chairman from 2006 to 2014, resulted in soaring asset price inflation, including a housing boom.

Stagflation inevitably brings many challenges, including poor economic growth, low productivity growth and rising debt. Money often gets misallocated to unproductive assets, while higher unemployment reduces worker skill development and means lower asset accumulation for retirement. Poor business confidence cuts capital expenditure and reduces incentives for entrepreneurs.

Stagflation inevitably brings many challenges, including poor economic growth, low productivity growth and rising debt
Andrew Hammond

The S&P 500 index lost about half its value in 1973-74 alone and real returns were subpar for much of the remainder of the decade. Meanwhile, bond investors faced the terrible twins of higher yields and inflation-hit returns.

A key reason why stagflation represents such a challenge is that it tends to resist traditional policy remedies, with neither fiscal nor monetary policy typically helping kickstart economies. This is because seeking to solve one problem, like soft demand, tends to worsen others, such as inflation.

One key lesson from these periods of stagflation is that favorable sectors tend to include energy and materials, while unfavorable ones are banks, commercial and construction. Consumer staples, including telecoms and nondurables, can potentially perform robustly too if they can raise prices.

In today’s landscape, policymakers are increasingly warning of the possibility of a new period of stagflation following the Iran crisis. The tipping point for a potential global recession, of course, depends in large part on how long the crisis lasts, how much damage is done and by how much energy prices and wider inflation rise. Oxford Economics warns that if global oil prices average about $140 per barrel for some two months, this would be enough to push parts of the global economy into recession.

Taken together, it is still too early to know if stagflation will take hold of key parts of the world economy. However, the growing number of red flags means we may be witnessing the initial warning signs of a repeat of a historical landscape that could have profound implications for incumbent political leaders.