I probably misunderstood. You run the installer manually once to generate the iss file right? And then on subsequent installs you can reference the iss to have a unattended installation?
In any case, the following should probably also work:
arguments: "-s -f1 setup.iss"
My point is simply that although you tell PowerShell about files in the current dir by using dot-slash notation (.\file.iss) that's not meaning you should use the same format when telling setup.exe about the same file's direction. PowerShell will just send whatever arguments you supply to the installer, which is why dot-slash won't work.
Glad you got it working.