Tyranny of numbers

Last month, the consumer price index (CPI) rose at annual rate of 9.4%, down from 37.4% the months before and far lower than its peak increase of 85% last October. By itself, this is no indication that inflation is slowing. Based on past experience, inflation is likely to go back up, but it may well be a sign that inflation is on its way down, the same way it happened after the previous two bouts of high inflation in the past decade. Inflation is the most important grievance of Iranian voters as they go to the polls this week, so it is worth taking the monthly drop seriously.

There is a striking pattern to the rise and fall of inflation in the last ten years into which the latest data fits nicely. This pattern is illustrated in the figure below, which shows the 3-month moving average of the CPI. There are three distinct periods of high inflation each lasting less than two years and each corresponding to a large negative macroeconomic shock. The first two happened after the imposition of US sanctions, by President Barrack Obama in 2011 and later by Donald Trump in 2018. Covid dealt the last shock starting in March 2020, which appears to be on its way out, especially if the latest CPI for Ordibehesht (April) is part of a trend.

Before getting into how the macro shocks affected inflation, one thing is already clear: this level of close correspondence between the timing of the external shocks (two episodes of sanctions in 2012 and 2018, followed by Covid in 2020) and inflation cannot be explained by independent changes in the fiscal position of the government. Rather these shocks caused the budget deficit to deteriorate, which caused liquidity to expand. 

The question of the source of Iran’s inflation is more than of academic interest; it is also hotly debated in the current presidential debate. The conservative candidates have emphatically placed the blame for inflation on the leading moderate candidate, Abdolnaser Hemmati, who was the governor of the Central Bank from August 2018 until three weeks ago when he was let go. As Hemmati has been arduously arguing, inflation was caused by sanctions, which he blames on the conservative and hardline forces in Iran. 

The mechanism that translates the external shock of sanctions to higher prices is not very complex. For example, the tightening of US sanctions in 2011 led to the collapse of the rial in October 2012, from about 11,000 rials per USD in 2011 to about 30,000 a year later. The price of imports nearly tripled, followed by lesser increases in other goods, and eventually wages. The same happened after the 2018 Trump withdrawal from the nuclear deal. In both cases, contrary to predictions of hyperinflation and economic collapse, inflation dropped after a while to a much lower level. 

The third external shock, caused by Covid, came when the Trump sanctions were in full force, but the inflation they had triggered had already lost steam. So the third shock, this time to domestic production, started a new episode of inflation. Like in other countries, social distancing disrupted domestic production and foreign trade — whatever was left of it — pushing the rial lower.

This narrative of inflation emphasizes external shocks but does not negate the fact that Iran’s budgets suffer from chronic deficits, which also cause inflation. In the last ten years, my guess is that about half of the average 20% inflation of the last decade was caused by external shocks and the rest by budget deficits. People who consider the Rouhani administration (or Hemmati) for the latest episode of inflation are wrong. Had Trump not reimposed sanctions in 2018 and Covid not arrived, today we would be experiencing the 10% average inflation rate of the 2014-2017 period would be in a very different electoral situation.

There are only two ways for the economy to adjust to a negative external shock, general price increase or reduction in employment. If the central bank does not accommodate the external shock, employment would have to contract as cost pressures from devaluation will force many enterprises to close. This is because nominal wages are sticky downwards and enterprises that lack the liquidity to pay higher wages would go out of business. 

In this situation, since real incomes do not fall by reduction in nominal wages, inflation has to do the job. Other relative prices — traded vs nontraded goods– also need to change, for which inflation is also the solution. In this scenario, the monetary authority expands liquidity to allow enterprises to raise money wages and for some prices to rise faster than others.  

Given the external source of inflation, the typical middle-class complaint that their incomes are falling because of inflation should be directed at the root cause of the external shock, not at the monetary authority’s decision to accommodate it. (By the way, a more precise complaint is that nominal incomes did not increase as fast as inflation, which is very different.)

The same goes for the related complaint of the loss of value of the national currency, which we have heard in the televised debates. Unfortunately, once the shock occurs, the only way to defend the nominal exchange rate is to suppress the resulting wage and price increases, which will have much worse consequences. Thankfully, we do not have the experience of such wage and price repression in recent memory in Iran, so we do not know how much social dislocation is needed to achieve it. But I take John Maynard Keynes’ word for it: “There has never been, in ancient or modern history, a community that has been prepared to accept without immense struggle a reduction in the general level of income” (quoted in Z. Carter, The Price of Peace).

Societies differ in how they deal with negative external shocks. Those with flexible economies (especially flexible exchange rates) and well-functioning political systems have a good chance of finding the least costly way to adjust to such shocks. To be sure, some decline in incomes will happen, but with sound economic policies combined and a societal understanding that the decline is fairly shared, the damage can be minimized. In contrast, societies that lack one or both of these qualities — do not allow markets to reallocate resources or the powerless bear the brunt of the shock — are likely to suffer losses greater than necessary.