The growing odds of a US stagflation trap

IN RECENT weeks, a growing number of expert observers have been raising the possibility that due to high oil prices caused by the Iran war, the US economy could find itself mired in stagflation – stagnant growth amid rising inflation.

In a series of posts on X two weeks ago, chief economist at Moody’s Analytics Mark Zandi said that the company’s machine learning-based economic model had put the probability of a US recession – defined as two consecutive quarters of negative gross domestic product growth – at 49 per cent, “even before disconcerting events in the Middle East”.

“It isn’t a stretch to expect the indicator to cross the key 50 per cent threshold amid the Iranian conflict and the resulting surge in oil prices,” Zandi said, noting that every recession since World War II – except during the Covid-19 pandemic – was preceded by a jump in oil prices.

Also a fortnight ago, Nobel Prize-winning economist Joseph Stiglitz said the US was the country most at risk of falling into stagflation, as it did during the 1970s oil shocks.

To be sure, even before the war erupted on Feb 28, Stiglitz said the US economy was already “close to stagflation”.

The numbers provide some support for this worry – US GDP rose at an annual rate of 0.7 per cent in the fourth quarter of 2025, sharply down from an earlier estimate of 1.4 per cent, and well below the third quarter’s 4.4 per cent advance.

For much of 2025, the dominant narrative around the US economy has been one of resilience. Growth has held up, the labour market has remained firm, and inflation, while stubborn, appeared to be gradually easing.

That narrative is now at risk of being overtaken by a worrying one: the return of stagflation.

History suggests that when energy costs surge, the consequences rarely remain confined to the pump.

Higher oil prices feed directly into transport, logistics and production costs, seeping into virtually every corner of the economy. The result is cost-push inflation at a time when inflation is already proving sticky.

This is where the policy dilemma begins.

Oil-driven inflation

Unlike demand-driven inflation, which can be cooled by higher interest rates, an oil-driven inflation shock is largely outside the US Federal Reserve’s control. Tighten too aggressively and the economy risks stalling, hold back and inflation risks becoming embedded. It is the classic stagflation bind.

The timing could hardly be worse.

The US economy is already in a late-cycle phase. Fiscal support is fading, excess savings accumulated during the pandemic are being drawn down and the lagged effects of earlier rate hikes are still filtering through the system.

Into this mix comes a renewed oil shock – a classic catalyst for tipping an economy from slowdown into something more problematic.

Financial markets, which had for years been buoyed by expectations of rate cuts and a soft landing, may be underestimating this risk.

Stagflation is one of the few environments where both equities and bonds struggle simultaneously. If growth slows while inflation remains elevated, the usual policy backstops become less effective.

None of this is to suggest that stagflation is inevitable. The US economy has repeatedly defied pessimistic forecasts, and there remain areas of underlying strength.

But the balance of risks is shifting. As the Iran war enters its sixth week, rising oil prices, elevated inflation and a near 50 per cent recession probability form an uncomfortable combination.