Tyranny of numbers

So far the most visible improvement in the economy since Rouhani administration took office last August has been lower inflation.   Last Bahman (Iranian month ending on February 20, 2014)  the Consumer Price Index (published by the Central Bank) showed virtually no increase; the same month a year earlier it had jumped by 5.3%.  During the last three months (December 21 to February 20), the CPI rose by only 1.6%, compared to 7.2% a year ago.  What appears to be more stubborn is the real economy — output and employment that determine living standards.

Not everyone agrees that inflation has been falling fast.  Financial Times wrote of only  “a slight drop in the inflation rate from 39 per cent to 36.7 per cent since he took office.” But this is an error that journalists bent on sounding dramatic always make.  If you are reporting on the changes in inflation for only one year you cannot use annual rates; you need to use the monthly rate at which prices increase, a measure that been falling for about a year (see graphs here or here).

But this trend is unlikely to continue.  Inflation is poised to increase as energy and bread prices are set to rise early as part of a plan agreed with the Parliament, known as the Phase 2 of the subsidy reform program.   The price of natural gas was quietly raised before Nowruz, by 20% for residential and 30% for commercial users, and electricity rates have just gone up by 24%.   The Iranian press is reporting gasoline is to effectively double in price, to 10,00 rials per liter, up from 4000 and 7000 rials per liter for rationed and free purchase.

It is hard to imagine that these price increases will leave inflation unchanged, at less than one percent per month (about 15% per year).  Inflation got to be that low because energy prices have been fro zen for the past three years and, more importantly, Rouhani slashed spending for 1392 and restrained the growth of money supply.

While tight fiscal policy will probably continue, monetary policy will have to ease somewhat to accommodate the rise in energy prices.  This is unavoidable because major relative prices changes need some inflation to work their way through the economy.  This is because wages and therefore most prices are rigid downward.  An interesting article in Fars News by Pesaran and Salehi Esfahani — much better macroeconomists than I — stated that energy prices can in principle increase without inflation: “if aggregate demand remains constant, rising nominal energy prices will be accompanied by falling other prices.”  Much as I like to think like that, in believe the idea of other prices falling to make relative price change happen is a Friedmanite fantasy.  Energy intensive producers will raise their prices right after the government raises energy prices, which will put pressure on the monetary authorities to expand credit or print money, which will raise the general price level.  If the Central Bank attempts to fight this type of inflation it will impose an unnecessary high cost on the nation in terms of output and employment, which is why it will not do so.

The good thing about Iran’s inflationary process is that the link between prices and wages is not direct — there are no unions and wages abs salaries are not indexed.  This was the main reason why inflation in Latin America was self reinforcing.  In Iran, unless the Central Bank continues to pump money, beyond what is needed to help relative prices adjust.  This means that any inflation generated by the current round of energy price increases need not last beyond 1393.

For the current year, the government predicts an inflation of 20-25%, which is much more than is needed to accommodate a similar increase in energy prices.  There is an underlying inflation rate of 10-15% linked to rising oil revenues and salary increases for 1393 that would put inflation in 1393 in the ball park of the government forecast.

It is important to note that, except for gasoline, the energy prices so far reported by the press, ranging between 20-30 percent, do not count as subsidy reform.  If the general prices level increases by 20-25 percent in the coming 12 months, then very little of the subsidy accumulated in the last three years will be eliminated.  The real implementation of the Phase 2 of the subsidy reform is therefore a long way off.