By Anis Chowdhury
SYDNEY, Apr 21 2026 – The global economy, is at the precipice of “stagflation” – growth slowdown and higher inflation – due to the energy price shock following the illegal US-Israel war on Iran. The International Monetary Fund (IMF) has recently termed this as a “textbook negative supply shock”. For the first time since the 1970s, the prospect of stagflation seems real.
Anis Chowdhury
What can central bankers learn from the 1970s stagflation?
Prospects of global stagflation
The IMF simulated three possible macroeconomic scenarios depending on the duration of this conflict and the extent of damages to energy infrastructure in the region. These range from a marginal drop in this year’s forecast global growth rate – from 3.4% to 3.1% – to a moderate decline to 2.5% and a sharp decline to 2%. The projected spikes in “headline inflation” – covering all goods and services, including volatile items, e.g., energy and food – range from 4.4% to 5.8% in 2026.
The IMF rightly doubts whether inflation can be checked with monetary tightening without causing substantial increase in unemployment. But it does not offer any solutions; instead advises the central banks to remain ready “to act decisively to maintain price stability”.
The IMF’s overall policy advice is conservative. However, it acknowledges the need for monetary and fiscal policy to support economic activities if the if financial conditions tighten sharply and global activity deteriorates markedly.
Inflation phobia and policy over-reaction
Ben Bernanke and his co-researchers found that the recession in the 1970s did not result from the oil-price shocks “per se, but from the resulting tightening of monetary policy”. Bob Barsky and Lutz Kilian found “that the oil price increases were not nearly as essential a part of the causal mechanism generating the stagflation of the 1970s as is often thought”. Ed Nelson blamed central banks’ “faulty doctrine” for the 1970s stagflation.
So, it was not inflation that caused output to decline, but rather, inappropriate and draconian efforts to curb inflation that inevitably repressed growth, and produced world’s first stagflation. This may happen again if central bankers overreact and tighten the financial conditions to kill the current “textbook supply shock” inflation.
The problem is the central bankers’ dogmatic group-thinking despite contrary empirical evidence. For example, the fear of unhinged inflation expectations and wage-price spirals do not have any empirical basis as reported in IMF research and the Australia’s Reserve Bank.
Yet, the central bankers and the IMF favour monetary tightening fearing the risk of “unhinged” inflation expectations and wage-price spirals.
Revisiting the inflation target
The central bankers’ group-thinking bias insists on an inflation target of 2% – a figure “plucked out of the air”, yet became “global economic gospel”. Don Brash, the acclaimed former Governor of the Reserve Bank of New Zealand, who was the first central bank governor to adopt a 2% inflation target admitted that it was based on a chance remark by then New Zealand Finance Minister Roger Douglas “during the course of a television interview”. It became “the mantra, repeated endlessly” as Brash and his colleagues “devoted a huge amount of effort” to preaching his new gospel “to everybody who would listen – and some who were reluctant to listen”.
Olivier Blanchard, the IMF’s former Chief Economist, questioned the wisdom behind the 2% inflation target and argued for a higher, e.g., 4% target following the 2008-2009 global financial crisis. IMF research also advocated for a long-run inflation target of 4%. Such a moderately higher inflation should widen policy space.
Joe Gagnon and Chris Collins argued that “the case for raising the inflation target is stronger” than it is usually thought. Their research revealed that “the benefits [of a higher inflation target] clearly exceed the costs”.
Thus, one should not be surprised when The Financial Times says, “It is time to revisit the 2% inflation target”.
Rethinking inflation
Almost all central bankers see inflation as an outcome of excess demand, caused by either an increase in aggregate demand or a decrease in aggregate supply at a given price. Prices rise to eliminate the excess demand.
A common view is that higher prices lead to demand for higher wages which in turn cause higher prices, thus generating wage-price spirals. Therefore, central bankers focus on containing demand by raising interest rate regardless of the sources of inflation.
On the other hand, optimal policy-mix differ when inflation is seen as the result of a distributional conflict or disagreement. Guido Lorenzoni and Iv´an Werning analysed the impacts of supply shocks arising from “non-labour” inputs, such as energy under the different relative bargaining powers of labour and firms where the non-labour input price is perfectly flexible, and goods prices are more flexible than wages.
They found that the optimal policy response to a supply shock coming from the scarce non-labour input is to “run the economy hot”, i.e., to allow demand to exceed supply capacity and higher inflation. Their findings imply that it would be more efficient to reach the adjustment with the help of higher price inflation than through lower price inflation and deeper wage deflation by causing higher unemployment.
David Ratner and Jae Sim analysed the trade-off of anti-inflationary measures considering inflation as an outcome of distributional conflict. They found that restrictive anti-inflationary measures are more costly in terms of unemployment.
Interestingly, their finding corroborates the IMF’s observation that the aggregate supply curve has become flatter making restrictive anti-inflationary measures more costly in terms of higher unemployment. Unfortunately, the central bankers’ anti-inflation group bias dismisses the higher unemployment or growth declines due to restrictive policies as “short-term pains for long-term gains”.
Recent IMF research revealed permanent scars of recessions, including those arising from external shocks and macroeconomic policy mistakes; they all “lead to permanent losses in output and welfare”. The Lancet reported “substantial effects on suicide rates”. The Body Economic: Why Austerity Kills, investigated the human cost of austerity policies during economic crises to emphasise that health indicators can significantly deteriorate.
Optimal policy response
In light of the above, the central bankers should reconsider their hawkish anti-inflationary policy-setting.
The governments around the world are trying to ease fuel-price impacts by fiscal measures such as a temporary reduction of fuel excise duty, subsidies and price caps. The mainstream commentators, including the IMF, argue that these measures may have significant fiscal costs if the crisis lingers on, and would put extra-burden on central banks, which are focused on controlling inflation.
Significantly, the optimal policy-mix should include tax revenue raising measures. Governments should consider enhancing tax progressivity. In particular, an excess profit tax should be imposed on the beneficiaries of higher interest rates and fuel prices, such as banks and fuel companies to fund cost of living support measures.
Dr. Ken Henry, Australia’s former Treasury Secretary has recently argued that a 100% tax on windfall profits from gas would be “socially optimal”. Tony Wood held “A windfall profit tax may be the least-worst solution to the gas crisis”.
Research based on US data reveals that an excess profit tax reduces existing racial and ethnic inequalities and inequalities between groups with different educational attainments. It can also accelerate renewable energy transition when increasing geopolitical tensions and climate impacts threaten continued volatility in fossil fuel and gas markets.
Anis Chowdhury, Emeritus Professor, Western Sydney University (Australia). He held senior UN positions in Bangkok and New York and served as Special Assistant to the Chief Advisor for Finance (with the status and rank of State Minister) in the Professor Yunus-led Interim Government. E-mail: [email protected]
IPS UN Bureau
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