High and volatile inflation in Iran has been an endemic economic and social issue that has contributed to rising poverty and social tensions.
Iran’s CPI inflation has fluctuated sharply over the past two decades around its annual average of 20% (Figure 1.a.), and has been much higher than that of Iran’s emerging market and regional peers (Figure 1.b.). With the Covid-19 pandemic hitting Iran’s economy on top of preexisting US trade and financial sanctions and exacerbating the supply constraints, its annual CPI inflation reached nearly 50% at the end of FY 2020-21 (Iranian year that ended on March 20, 2021) and averaged 40% during FY 2021-22 (Iranian year that ended on March 20, 2022).
Coupled with low economic growth and high unemployment, rising inflation has fueled widespread protests in the country amid a significant erosion in purchasing power. The new government that took office in August 2021 identified tackling inflation as a key economic priority, reads a working paper published by the International Monetary Fund. Excerpts follow:
For policymakers to effectively address the inflation problem, it is critical to understand its causes. This paper studies the determinants of inflation in Iran to identify effective policies to fight it.
Using a Vector Error Correction Model, the paper quantifies the short- and long-term impacts of various domestic and external factors on inflation and illustrates alternative inflation scenarios using conditional forecasts. Using quarterly data between Q2 2004 and Q1 2021, it finds that whereas base and broad money growth drive inflation only in the long-term, nominal exchange rate depreciation vis-à-vis the US dollar, current (operating) budget deficits and oil export volumes (a proxy for sanctions intensity) are the main drivers of inflation in the short term.
Under the baseline (unconditional) forecast informed by historical data, inflation would continue rising in the next two years along with elevated deficits and continued depreciation of the rial. Under conditional forecasts with fiscal and monetary restraint, however, inflation would decline below 20% in the next two years, albeit at a modest cost to non-oil GDP. A stabilization in the exchange rate or an increase in oil export volumes (e.g., doubling within the next year), for instance, perhaps some sanctions relief, would also lower inflation significantly, while supporting non-oil GDP.
Historical Trends
As common in emerging market and developing economies, the consumption basket in Iran has been largely comprised of food and housing.
In FY 2021-22, for instance, food and beverages, utilities (electricity, water and gas), and transportation comprised 40% of the consumption basket, while other “core” items comprised the remaining 60%, half of which was housing (Figure 2.a.).
Although many food and energy items have been heavily subsidized in Iran, food and beverages, and housing and utilities, have been the largest contributors to inflation (Figure 2.b.). Food price inflation in Iran has markedly surpassed that in the rest of the world, especially when economic sanctions intensified during the early and late 2010s (Figure 2.c.). Housing rental prices have spiked in recent years, along with housing sale prices, as consumers hedge against inflation investing in housing, but also feeding inflation by raising rents (Figure 2.d.).
Domestic factors, such as loose fiscal and monetary policies, have been positively associated with inflation. Large fiscal deficits and rapid liquidity growth were associated with high inflation, particularly during the mid- 2000s due to expansionary government policies, during intensified sanctions in the early and late 2010s, and recently due to the Covid-19 crisis (Figures 3.a. and 3.b.). Negative real interest rates enabled by financial repression have likely added to inflationary pressures during intensified sanctions and the Covid-19 pandemic as well (Figure 3.c.). While non-oil output gap, computed using the HP filter, has not been clearly associated with inflation, non-oil output growth seems to have been positively associated with inflation, albeit at a one- year lag (Figure 3.d.).
On the external side, exchange rate depreciation has been highly associated with inflation. Renewed sanctions and the Covid-19 crisis, in particular, have led to a sharp depreciation in the market exchange rate, which in turn raised import prices and passed through to domestic inflation (Figures 4.a. and 4.b.). Import volumes also seem to be negatively correlated with inflation, particularly during intensified sanctions in the early and late 2010s that likely led to import shortages (Figure 4.c.). Sanctions have also decreased export volumes, which have been negatively associated with inflation (Figure 4.d.).
Oil prices, however, have been positively associated with inflation in the short term (Figure 4.d.). Nevertheless, the decline in oil prices accompanying the Covid-19 crisis was not enough to curb inflation fueled by a large currency depreciation, and expansionary fiscal and monetary policies amid ongoing sanctions.
The rise in the global oil and food prices since the beginning of 2021 and supply chain disruptions are also likely to add to inflationary pressures. Although the analysis focuses on the period before Q1 2021, the rise in commodity prices and shipping costs, as well as supply shortages following the global demand recovery from the Covid-19 pandemic and the impact from the war in Ukraine are a source of continued inflationary pressures, especially for emerging markets with weak monetary frameworks and unanchored inflation expectations like Iran.
Model Estimates
In the long term, money supply, nominal exchange rate and budget deficit have a significant positive impact on inflation, whereas oil exports have a negative one.
According to the baseline co-integrating equation, an increase in base money (nominal exchange rate) of 1% increases inflation by 0.5% (0.2) in the long term. Likewise, an increase in the current fiscal deficit of 100 trillion rials (about 25% of the 2020-21 quarterly mean) increases inflation by 0.2%. Oil exports (under sanctions), on the other hand, have a significant negative impact on long-term inflation: an increase in oil export volume of 1% decreases long-term inflation by 0.35%. Whereas the long-term impact of oil prices on inflation is insignificant, likely resulting from offsetting effects of oil prices on inflation through oil export receipts versus non-oil import bill, the long-term impact of real non-oil GDP on inflation is positive, likely reflecting low capacity-utilization under sanctions amid low investment, for instance in imported technology.
Long-term relationships remain largely unchanged under alternative model specifications. Table 1 shows that the sign and significance of long-term coefficients remain largely unchanged when using current expenditures (CEX) instead of current deficit (CD) in column (2); when using real oil gross value added (RGVAo) instead of oil exports (OilX) in column (4); when using real exchange rate (RER) instead of nominal exchange rate (NER) (in column 5); when using global food price (FoodP) instead of global oil price (OilP) (in column 6); and when using real non-oil imports of goods and services (IMP) instead of oil price (OILP) — the only insignificant term in model 1 — to account for potential supply constraints (e.g., import compression due to the pandemic or sanctions). Including broad money (M2) instead of base money (M0) in column (3), however, results in a reversal of the positive long-term relationships of non-oil output and nominal exchange with inflation, and yields a positive long-term relationship between oil prices and inflation. Nevertheless, the positive long-term relationship of fiscal and monetary policy variables (oil exports) with inflation remains unchanged in all specifications.
In the short term, only the nominal exchange rate, current budget deficit and sanctions have a significant positive impact on inflation. Figure 6.a. (Appendix Figure 1.a.) shows the responses of inflation to innovations in the independent variables in the baseline specification (1).
While inflation has a positive response to all explanatory variables but oil exports, only the nominal exchange rate, current deficit and sanctions significantly raise inflation in the short term. For instance, a one standard deviation innovation in the nominal exchange rate and current deficit would increase inflation in the next four quarters by 3.8% and 3%. Figure 6.b. shows the variance decomposition of model (1) and confirms that the nominal exchange rate strongly predicts variation in inflation, along with current deficits and sanctions (oil exports). Around 70% of the variation in inflation are explained by these three variables by Q4. Base and broad money, however, do not strongly predict variation in inflation in the short term. Even so, monetary policy could affect inflation indirectly through changes in the exchange rate, aggregate demand and adjustment to the long-term equilibrium.
Policy Implications
The high inflation rates in Iran can be explained by both external and domestic factors that are hard to disentangle and that feed one another. Sanctions contribute to inflation directly through import shortages and supply constraints, and indirectly through depreciating exchange rates and higher government deficits resulting from lower oil exports and foreign exchange receipts. Lack of external funding in turn means that fiscal deficits are increasingly financed by lending by banks and Iran’s sovereign wealth fund (NDFI) which, in turn, expand the supply of money. Expansionary monetary and fiscal policies on top of sanctions, such as through cheap private credit and higher government spending, fuel inflation further, and in turn feed back into depreciating exchange rates.
The policy mix in Iran has relied too heavily on distortive price controls, which can contain inflation only temporarily, albeit with negative long-term consequences. Iran has employed price controls on various goods and services, including energy (such as electricity and petroleum products), foodstuffs (such as wheat, through a guaranteed price to producers and a subsidized exchange rate for importers that was recently scaled back), and financial services (through interest rate ceilings).
While used as a tool for socioeconomic policy (such as protecting consumers and workers, supporting producers and promoting targeted sectors), price controls often undermine investment and growth, worsen poverty and inequality, impose large fiscal burdens and weaken the effectiveness of monetary policy (World Bank, 2020).
Replacing price controls with expanded and better-targeted social safety nets would be more effective and less costly in achieving social protection objectives. A sustained reduction in inflation will require a fundamental shift in the policy mix involving fiscal, exchange rate, monetary and structural reforms.
While sanctions relief would promote a faster decline in inflation by helping stabilize the exchange rate and facilitate the implementation of difficult reforms, these reforms are needed even more urgently in the absence of sanctions relief and should be implemented gradually.
