The scope for conventional monetary policy in Iran is extremely limited due to capital controls, the central bank's lack of independence, financial repression and entrenched inflationary expectations. As a result, attempts to control the exchange rate, interest rates and inflation are often ineffective—or even counterproductive.
In theory, the depreciation of the rial forces the Central Bank of Iran (CBI) to conduct unsterilized foreign exchange interventions to prevent further depreciation. In practice, this means the CBI sells foreign assets and purchases rials. The purchase of rials reduces the CBI’s reserve liabilities, leading to a contraction in the monetary base. A smaller monetary base reduces the money supply, with the exact impact depending on the money multiplier. Lower money supply then pushes interest rates higher, increasing expected returns on rial-denominated assets. In theory, this should attract capital inflows, increase demand for the domestic currency and support an appreciation of the rial.
This is, however, not what the CBI is fully capable of doing in practice. First, it does not have sufficient international reserves to conduct frequent interventions. The CBI’s foreign reserves are estimated at around $33 billion, and following a $107 billion decline since 2018, such interventions have become increasingly difficult. Second, capital controls restrict not only outflows but also potential inflows. Even if interest rates rise enough to attract foreign investors, there is little incentive to invest because they may not be able to repatriate their funds easily. Third, and perhaps most importantly, official interest rates differ substantially from market rates, limiting the monetary transmission of unsterilized interventions to the exchange rate.
The CBI can also conduct sterilized interventions to rebuild its international reserves, but this too is highly challenging. Open market operations are of limited use when government debt securities are illiquid and demand for government bonds remains weak.
In terms of interest rates, Iran’s real interest rate is deeply negative. Taking the 17% standing deposit rate as the nominal interest rate and inflation at 48.3%, the real interest rate stands at -31.3%. This means that, in real terms, lending results in a loss. As a consequence, households prefer inflation-hedging assets such as real estate, gold and foreign exchange, which are viewed as more reliable stores of value. Besides contributing to financial repression, this behavior fuels asset price bubbles, particularly in the property market, creates liquidity management challenges for private banks and adds to short-term inflationary pressures. The widespread use of foreign currency as a store of value also reinforces the depreciation of the rial.
Raising nominal interest rates above the inflation rate—which would require an increase of more than 20 percentage points—is also far from straightforward. Higher interest rates would increase the government's borrowing costs, an undesirable outcome for a country running a budget deficit exceeding 6% of GDP. They would also increase banks' liabilities and raise the risk of widespread insolvency.
Achieving price stability is similarly beyond the CBI’s reach under current conditions. The central bank lacks operational independence and therefore faces persistent pressure to monetize government debt. At the same time, meaningful open market operations are constrained by illiquid government bonds and underdeveloped primary and secondary debt markets. Persistent inflationary expectations and speculative attacks further undermine the effectiveness of monetary policy.
The solution lies in strengthening the CBI’s independence, implementing regulatory reforms and pursuing a comprehensive strategy to develop Iran’s financial markets.
