Dollar Pauses, Prices Don’t

Many people and officials believe that whenever the exchange rate increases, all other goods and services follow suit. Therefore, the consumer price index in the Iranian year 2021-22 should have been zero as well, but this has not been the case.

Amin Kavee, an economic researcher, examines this anomaly in an article for the Persian economic daily Donya-e-Eqtesad. 

A translation of the text follows: 

Why did prices increase despite the stability of foreign exchange rate?

The growth in prices was not because of the dollar. Excessive growth in money supply is the reason behind the constant, gradual increase in prices of goods and services. Meat, car and even the dollar itself are no exception.  

The basket of consumer goods and services consists of a variety of domestically-produced and foreign items and not just foreign goods. Economy is affected by macro-level balances.

What is excessive growth in money supply?

For reasons such as “government budget deficit”, “commercial bank imbalances”, or “negative or low economic growth”, the economic imbalance manifests in the form of an increase in money supply, which is higher than the rise in economic output.

In other words, excessive money growth occurs when money is added to the banks’ balance sheets in the shape of “deposit interest” or “new loans”, whether for the “final consumption by governments” (from paying salaries to the employees of public sector employees to the construction of roads, schools and hospitals) or for “final consumption by people and the private sector”. As a result, the economy faces rising prices to offset the effect of money growth.

So, why does the exchange rate of the dollar increases before each inflationary wave?

The price of some assets (foreign currency, gold, etc.) is likely to increase sooner, given their higher liquidity and lower transaction and maintenance costs. The early rise in the price of these assets as a result of inflationary expectations leads to the wrong belief that “the growth in the future prices of goods and services that follow them has been driven by the rise in the price of foreign currency” rather than both. 

Assets are also prone to short-term herd mentality because of speculative practices, meaning that as prices rise slightly, traders seek to buy more dollars or gold in order to generate more profits that, in turn, further increase the price of the asset. When the bubble bursts, markets once again pursue long-term behavior by tracking and coordinating with the “excessive money growth”.

The early increase in foreign exchange rate gives the wrong idea that the dollar itself is the driver of prices. 

Are inflationary expectations resulting from increases in foreign exchange rate a cause for inflation?

As inflationary expectations increase, people try to make up for their future lag in the prices of goods they consume. So they raise the prices of the goods they supply themselves in the hope of making more money; they might even hoard items to make more profit. All this causes a price increase in the short term that won’t be permanent and cannot be labeled as inflation. If the growth of money is less and is not in line with inflation expectations, after a while the money fueling transactions at new prices will come to an end and the price hike stabilizes and returns to the pace of growth in excess money supply.

Weren’t the sanctions and decline in the supply of foreign resources the drivers of inflation?

Oil-driven economies usually spend oil revenues on imports when their foreign resources increase. Under such circumstances, despite budget deficits and bank imbalances, their inflation rates fall below the levels commensurate with the growth of excessive money supply but because of the non-commercial nature of local labor and other services, producer and consumer inflation do not disappear. 

If the trend persists, the real exchange rate gradually decreases, the non-competitive nature of their exports becomes irrelevant and imports become much more economical. But in the future, as the demand for foreign source revenues and the pressure on the exchange rate continue to grow, imports become more expensive and exports get cheaper, so the balance will be restored. 

This does not happen in economies reliant on natural resources because the efficiency ratio of natural resources is very high and they remain profitable for a long time. For example, the production of a barrel of oil costs $8 but it sells at $100, which means it may take years or decades for oil production to become uneconomical. The phenomenon is called the Dutch disease.

As a result, the fall in the real exchange rate will continue to a great extent. Foreign sanctions or decline in global prices of natural sources might stem the inflow of revenues. The economic players, however, keep on demanding foreign services and goods despite the sharp decline in foreign currency supply. The exchange rate would inevitably jump and the price of foreign goods will rise sharply.

But domestic enterprises that manufacture similar foreign products, if they have not been shut down following the outbreak of the Dutch disease in the economy, have limited capacity; they cannot meet the needs of consumers who used to avail themselves of foreign products. So the price of domestic goods will surge and whatever inflation had been accumulated over the years would all manifest in the economy. Of course, after these surges, the prices will again align with the growth of money.

In fact, sanctions boost the gunpowder depot of inflation; they are not the sole cause of inflation. In the absence of bank and budget imbalances, there would be no gunpowder depot to cause the fire of inflation.

In summation, although the foreign exchange rate has not changed in the past 12 months, the economy registered a 35% inflation rate in consumer goods and services due to the government’s budget deficit and the imbalance of banks. If the increase in general prices was a function of the dollar value, we should now be experiencing a zero year-on-year inflation rate, which is far from reality.