Policymakers are going into an examination hall
Business Standard, 7 June 2026
How does the world economy shape up when faced with a big energy disruption? The decade of the 1970s provides us with the essential reference point. From the Yom Kippur War to the Iranian Revolution, we got an overall 12 times increase in the price of crude oil.
Modern macroeconomic policy was made out of the 1970s oil shock
At the time, developed economies correctly passed on all petroleum product price hikes to the consumer. This permitted the price system to work. Consumers and firms faced the true cost of energy. This led to lower demand and higher energy efficiency. But the advanced economies operated in a muddled intellectual framework on macroeconomic policy. Policymakers attempted to manage exchange rates. Monetary policy was not, then, fundamentally organised around the inflation target. Central banks tried to be kind to the people, accommodating the supply shock with loose monetary policy. This worked poorly. The 1970s were a bad place for economic growth in developed markets, not solely because of the jump in the price of oil, but because macroeconomic policy failed.
Modern macroeconomic knowledge was literally built out of these difficult experiences. The intellectual advances of floating exchange rates, independent central banks, and inflation targeting were born of the failures of alternative ideas when faced with the oil shock. The Great Moderation, of good macroeconomic outcomes from 1984 to 2007, was created by these intellectual advances.
DMs will weather the 2026 shock well
Because of this institutional learning, the 2026 oil shock is likely to affect developed markets in a more mild way. The physical shock is large, but their macroeconomic policy machinery is better prepared when compared with the conditions of the 1970s. Advanced economies now hold institutional credibility around their inflation targets. They possess floating exchange rates that absorb external shocks. For them, petroleum product price hikes generally reach customers. When international crude prices spike, consumers see higher energy prices, which initiates the necessary microeconomic adjustment. For oil importers, the exchange rate depreciates to restore external competitiveness. The central bank raises interest rates to anchor inflation expectations.
Macroeconomic policy cannot change the pain of higher energy prices. Only the microeconomy, one firm and one household at a time, responds to these changes with modified behaviour. What macro policy can do is to help by creating conditions of macro stability.
15 EM policy makers going into an examination hall
What about emerging markets in this environment? EMDEs are now 43% of global nominal GDP; what happens in EMs matters a lot for the world economy. Institutional quality in emerging markets is superior when compared with the problems seen in the late 1990s in the East Asian Crisis. Exchange rates are somewhat more flexible. Central banks have generally received the formal legislative goal of inflation targeting. But the reality diverges from the promise. The de facto operation of state agencies differs from the de jure framework. When confronting the 2026 oil shock, emerging markets suffer from policy limitations in three respects.
- The first limitation lies in microeconomic policy. Some emerging market policymakers show an unwillingness to trigger the required adjustments in the economy through price fluctuations. Instead, some governments have prevented retail fuel price hikes to shield consumers. This is inefficient microeconomics. It places a fiscal burden upon the state. It prevents the demand adjustments necessary to balance the market. When prices are suppressed by state fiat, we get shortages. The economy faces rationing and government-controlled allocation. The impulse to shield the citizenry from price volatility ultimately gives the citizenry a bad deal in the form of reduced economic growth.
- Of greater consequence are the problems of macroeconomics. The second limitation is the fear of exchange rate flexibility. An open economy relies on the exchange rate as a shock absorber. When an energy importing nation faces an oil price shock, currency depreciation is a normal response of the market economy. This discourages imports and makes exports more competitive. However, when the government interferes with exchange rate depreciation, this harms the ability of the economy to respond to external shocks. A distorted exchange rate acts as a subsidy to importers, a tax on exporters and a red carpet for capital exit.
- The third limitation, and as yet a looming concern, is about inflation. What weight will central banks attach to inflation? Will central banks actually do inflation targeting, even when this demands interest rate hikes at a time when the economy is not faring well? Supply shocks inherently reduce output and raise prices. If the central bank prioritises short-term growth over its inflation mandate, this will go against the problem of anchoring inflation expectations. The credibility of an early stage central bank is tested during such crises.
These three problems add up to an important test of policy capacity in emerging markets and developing economies. Of the 24 countries in the MSCI EM index, 15 are energy importers, adding up to 29% of world GDP. These 15 countries are going into the examination hall, facing these shocks. Each of them engage in internal debates and disagreement, with the clash of ideas, interests and institutions. There will be a spectrum of outcomes, on how well they fare in the examination.
In the limit, there are countries where policy makers engage in administrative pricing of fuel, managed exchange rates, and weak monetary policy institutions, where the state overrides the judgement of the price system. For these countries, the analogy with developed economies of the 1970s may prove to be important. They run the risk of facing more stagflationary outcomes. Further, they will leave this crisis holding reduced credibility of their policy making apparatus.
The global economic landscape is no longer dominated solely by advanced economies. Emerging markets are rather important in global consumption, production and contribute a disproportionate share of global growth. Success or failure in navigating this shock will reverberate on the global stage. The emerging market policymakers which go with the grain of the price system and adhere to macroeconomic orthodoxy are likely to achieve better macroeconomic outcomes during this period, and additionally emerge from this crisis with enhanced credibility of their policy institutions.
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