Why Iran is experiencing hyperinflation & why we could too

The value of the Iranian currency, the rial, has plummeted in recent weeks triggering a condition known as hyperinflation.

A nation experiences hyperinflation when its “cumulative rate of inflation over three years approaches or exceeds 100%”, at least that’s the official definition according to International Accounting Standard (No 29), as defined under Generally Accepted Accounting Principles (GAAP). This works out at about 26% a year, and although Iran’s official inflation rate was calculated at 23.5% for the month ending 20 August, Steve H. Hanke, a senior fellow at the Cato Institute, estimates that the true monthly inflation rate has reached 69.6%.

A 100,000 rial banknote

As the BBC reports, “In the past seven days, Iran’s rial has lost 25% of its value; it is now, at best, worth only a quarter of what it was 18 months ago.”

There can be no doubt then that Iran is experiencing hyperinflation. The question is why?

Currency manipulation

The first obvious reason is that Iran’s central bank, which has been manipulating the currency for years, is no longer able to do so. Their manipulation worked by injecting petrodollars into the market to keep the rial’s value against the US dollar high. And it was funded by the sale of crude oil, which in 2011 generated around $100 billion in revenue.

Earlier this year however, the US and the EU stepped up their efforts to force Iran to curtail its nuclear programme. In doing so they imposed sanctions against any entity which dealt with the Iranian Central Bank, a measure which deterred many financial institutions from doing business with the country.

As a result of the sanctions Iran’s oil exports have fallen by 55% since January 2012. It therefore has access to significantly fewer US dollars with which to boost its currency, especially since much of the oil is Iran is still able to sell is paid for in gold rather than in dollars (thereby bypassing this SWIFT international settlement system).

Without the artificial support of Iran’s central bank, the value of the rial has fallen dramatically. On the black market in March of this year it took around 19,000 rial to buy one US dollar, now however it takes as much as 35,000 rial to buy one dollar.

The fact that Iran’s currency manipulation has ceased helps explain why their currency has fallen versus the US dollar, however it does not explain the country’s domestic inflation.

Money velocity

Inflation is defined as an increase in the supply of money and credit, and according to the World Bank, the money supply in Iran has been increasing at 20 to 30% per annum for most of the past decade.

The price of goods and services in an economy rise when new money joins the existing money in circulation and it is used to bid up prices. Essentially the increase in the money supply creates a condition where more money chases the same amount of goods, and the law of supply and demand states that prices must rise. Of course what’s really happened is that the purchasing power of the money has fallen.

Inflation however, doesn’t come solely from an increase in the supply of money, it also requires an increase in what’s known as money velocity, and it is money velocity that has played a big part in Iran’s inflation.

Money velocity refers to the rate at which money changes hands within an economy. More specifically the velocity of money is the average frequency with which a unit of money is spent in a specific time frame.

Money velocity is a key component in both inflation and deflation because these phenomena are not purely functions of how much money is in the system. They are also functions of how fast that money is moving through the system.

When banks are lending, businesses are borrowing, and consumers are spending, money changes hands quickly and money velocity is high. Conversely, when banks are not lending, and businesses and consumers are saving, or paying off debt, rather than taking on new debt, money does not change hands quickly and money velocity is slow.

The bottom line

Iran’s hyperinflation has been caused by a long-running policy of money printing, coupled with a sharp increase in money velocity which was ignited by the recent sanctions imposed on the country. Money velocity typically picks up when consumers and businesses expect the price of goods to be higher tomorrow than they are today, this leads to an increase in what’s known as inflation expectations. And a pick up in inflation expectations helps spur money velocity.

What’s happening in Iran today is what I expect to happen both in the US and the UK in a few years, only not to the same degree.

Since 2009 the Bank of England (BoE) has pumped £375 billion into the UK economy in an effort to spur economic growth. However the vast majority of that freshly printed money is just sitting in the banks, and isn’t therefore contributing to GDP.

It’s my guess that at some point the BoE (and the Fed) will be instructed to find a better way to get the new money out into the economy, and when they do they will ignite money velocity. At that point we will likely enter a period during which the true rate of inflation averages 10 to 15% per annum.

In just four years an inflation rate of 15% will have reduced the purchasing power of the pound by 47.8%. The challenge for investors and those with wealth and savings will be keeping ahead of inflation. In such an environment, gold should be the standout performer, however other hard assets such as copper, oil and agricultural commodities are also likely to do well.

It’s worth noting that in 1975 the annual inflation rate in the UK (RPI) peaked at 24.2%, only just shy of the 26% hyperinflation threshold. So although I don’t expect hyperinflation here in Britain, we came close just 37 years ago, so we shouldn’t rule it out.

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