Is Iran’s inflation deflating economic recovery?

President Hassan Rouhani is having a hard time convincing people in Iran that he can match his spectacular success in foreign policy with domestic policy. His Reformist backers are criticizing him for not doing enough to open up the political space, and ordinary people are complaining about lack of improvements in the economy. To do well in the upcoming February 2016 parliamentary election, he needs to convince voters that he can deliver on his chief economic promise: to grow the economy and create jobs.

The initial economic bounce from Rouhani’s election in June 2013 and the signing of the Joint Plan of Action (JPOA) later that year ended nine quarters of negative economic growth and added 2-3% to the gross domestic product in the Iranian calendar year of March 2014-March 2015. Despite the successful negotiation of the final nuclear agreement with six world powers in July 2015, the initial momentum has been lost.

Many blame the lackluster performance of the Iranian economy this year — it is barely growing — to economic austerity aimed at bringing inflation down to single digits. Annual inflation reached a high of 34.7% in the Iranian calendar year from March 2013-March 2014, when Rouhani was elected, and dropped to 15.5% the following year.

But not all of the decline in inflation is due to Rouhani’s austerity. Inflation was on its way down several months before Rouhani took office, in part because the inflationary shock of the 2012 devaluation was wearing off and in part because of global deflation. Food prices have declined by one-third since 2011, as have other commodity prices. The stability of the exchange rate, for which Rouhani can take some credit, has helped translate these declines intolower import prices in Iran.

No matter what has brought inflation down to its current level, pressure on Rouhani is mounting to abandon his goal of single-digit inflation and to loosen the austerity reins. As time passes and rampant inflation becomes a thing of the past, people’s attention is turning to the real side of the economy — production, jobs and real wages.

Slower rising prices initially made Iran’s inflation-wary public content. But this was only for a short while, before they realized that slower rising prices also mean slower rising nominal incomes. During the Iranian year of March 2014-March 2015, wage and salary earners actually gained as their real average wage increased by about 10%, according to the latest survey of urban incomes and expenditures published by the Central Bank of Iran. But the self-employed urbanites took a beating: Their real incomes fell by 12%, bringing the overall average in real earnings down by 1%. This year, despite relatively moderate inflation, real earnings will probably fall by more.

Investors are equally unhappy because the Tehran Stock Exchange (TSE), which had been booming under sanctions, has been in the doldrums since December 2013, losing one-third of its value. It remained bearish even after the July 14, 2015, nuclear agreement, called the Joint Comprehensive Plan of Action (JCPOA), was signed. The TSE has not done too badly overall, its general index having risen by 275% between August 2012 and December 2013. In any case, Iran’s stock exchange is too small to indicate much about the country’s economic health. The popular economic website Eghtesad News noted this week that the combined value of companies listed on the TSE equals Starbuck’s value. But, for better or for worse, as in China, it has become a barometer of business confidence in Iran.

Even if the TSE index is not very informative about the economy’s overall health, it is about the health of the firms it represents. The private sector is under huge stress from international sanctions, low oil prices and economic austerity. This stress has been transmitted to the banking system, which has an unknown amount of nonperforming loans and faces a tough Central Bank that is keen to regain its footing after years of mismanagement under former Iranian President Mahmoud Ahmadinejad. Interest rates are more than 10 percentage points above the rate of inflation, as banks and credit institutions fight to attract deposits and apply caution in their lending.

In the meantime, domestic industry is in a dire state. Bad news came this month from the most recent survey of medium and large industries, which showed that its index of industrial output had declined by 2% last spring, falling back to its lowest level reached under Ahmadinejad.

Indeed, last month, in a highly unusual move, four senior members of Rouhani’s Cabinet — the ministers for economy, labor, defense and industry — wrote a letter to the president warning that “the recession might turn into a crisis.” The letter, which was made public this week, singled out the TSE’s drop as the main cause for concern. Interestingly, perhaps in response to the ministers’ letter, the government recently announced a $100 million cash subsidy to industry. Much of this money is expected to go to the auto sector, which is coping with unsold cars produced following the sanctions relief it received under the JPOA nearly two years ago.

All in all, will these pressures force Rouhani to abandon his goal of single-digit inflation? Some economists warn that doing so now would be very costly. This is because expectation of inflation, which strongly influences future inflation, is on its way down and perhaps close to breaching the 10% threshold. Moreover, stabilizing inflation in the 15-20% range at this critical time, they warn, would freeze inflationary expectations at that high level and ensure double-digit inflation for years to come. Such a scenario exposes the economy to other risks as well, principally of a sizable devaluation.

The exchange rate has remained surprisingly stable in the last three years despite the much higher rate of inflation in Iran compared to the rest of the world. To bring the exchange rate close to what it was in early 2013 in real terms, the rial would have to devalue by close to 50%. Bearing the latter in mind, the reality is that the later inflation drops below 10%, the greater the danger of a large devaluation in the near future. Such an event would in turn trigger another round of inflation and further economic instability.

The one bright source of hope for escape from this bleak predicament is the inflow of money from abroad. Iran expects to receive an estimated $50 billion from the release of its frozen funds, and a few billions from foreign investment. Any infusion of cash from abroad, like oil revenues, creates upward pressure on prices. However, such pressure would be far less compared to injecting printed money into the banks and businesses. The real problem with the funds from abroad is that they are likely to come too late to influence the outcome of the parliamentary election in February.

To no one’s surprise, Rouhani’s opponents are doing all they can to make sure this is the case by delaying the passing of the JCPOA review in the parliament and dismissing any talk of normalizing relations with the West. Foreign investors ultimately need the latter in order to bring in serious money. For Rouhani, matching his success in foreign policy with domestic policy will be no small feat.