Inflation Increase in Latvia: Inflation Increase in Latvia: A Short-Term Phenomenon or a Risk A Short-Term Phenomenon or a Risk Associated with Demand Pressure?Associated with Demand Pressure?

Christoph B. RosenbergChristoph B. RosenbergSenior Regional RepresentativeSenior Regional Representative

International Monetary FundInternational Monetary FundWarsaw Regional OfficeWarsaw Regional Office

Latvia's Inflation in Latvia's Inflation in PerspectivePerspective

** Baltics and EU8 exclude Latvia.Baltics and EU8 exclude Latvia.Source: Eurostat.Source: Eurostat.

HICP in Latvia vs. Baltics*, EU8*, EU15, Scandinavia (YoY, in percent)

-1

0

1

2

3

4

5

6

7

8

9

Jan

2000

Apr

200

0

Jul 2

000

Oct

200

0

Jan

2001

Apr

200

1

Jul 2

001

Oct

200

1

Jan

2002

Apr

200

2

Jul 2

002

Oct

200

2

Jan

2003

Apr

200

3

Jul 2

003

Oct

200

3

Jan

2004

Apr

200

4

Jul 2

004

Oct

200

4

Jan

2005

Apr

200

5

Latvia Baltics EU8 EU15 Scandinavia

The SDR Peg and Inflation The SDR Peg and Inflation (a)(a)

Import-weighted NEER (Jan 2001=100)

75

80

85

90

95

100

105

110

115

Jan

-01

May

-01

Sep

-01

Jan

-02

May

-02

Sep

-02

Jan

-03

May

-03

Sep

-03

Jan

-04

May

-04

Sep

-04

Jan

-05

May

-05

EE LV LT

The SDR Peg and Inflation The SDR Peg and Inflation (b)(b)

Estimated impact of XR movements on HICP (Dec-Dec, percentage points)

-5

-4

-3

-2

-1

0

1

2

3

2001 2002 2003 2004 2005*

EE LV LT

Notes: Notes: NEER weights assume that imports from EU are priced in Euro, non-EU imports priced in dollars. NEER weights assume that imports from EU are priced in Euro, non-EU imports priced in dollars. Contributions to HICP estimated using weights based on imports to GDP ratios in each country.Contributions to HICP estimated using weights based on imports to GDP ratios in each country.** Jul-DecJul-DecSource: EurostatSource: Eurostat..

Supply-Side EffectsSupply-Side Effects

Latvia: Decomposition of inflation (YoY, in %)

0

1

2

3

4

5

6

7

8

9

Jan

-00

Ap

r-0

0

Jul-

00

Oct-

00

Jan

-01

Ap

r-0

1

Jul-

01

Oct-

01

Jan

-02

Ap

r-0

2

Jul-

02

Oct-

02

Jan

-03

Ap

r-0

3

Jul-

03

Oct-

03

Jan

-04

Ap

r-0

4

Jul-

04

Oct-

04

Jan

-05

Ap

r-0

5

Core Unprocessed food Fuel Regulated Total inflation

Source: National authorities.Source: National authorities.

Catch-Up to EU Price Levels (a)Catch-Up to EU Price Levels (a)

Cz

Est

Lat Li

Hu

Pol

Slk

Bul

Cro

Rom

Tur

20

25

30

35

40

45

50

55

60

65

20 30 40 50 60 70

Relative per capita GDP at PPPs

Rel

ati

ve

pri

ce l

evel

(ra

tio

of

mark

et t

o P

PP

ra

tes)

Relative price level vs. relative GDP per capita (PPP), 1995-2004

Source: Eurostat.

Catch-Up to EU Price Levels (b)Catch-Up to EU Price Levels (b)

Cost of living comparison in the European Union (Data refer to 1st July 2004)

60

65

70

75

80

85

90

95

Slovenia Slovakia Estonia Lithuania Latvia CzechRepublic

Hungary Poland

Source: EurostatSource: Eurostat..

Structural FactorsStructural Factors

Czech Republic 3.3 Czech Republic 3Es tonia 3.3 Hungary 3Hungary 3.3 Lithuania 3Poland 3.3 Poland 3Latvia 3 Slovakia 3Lithuania 3 Es tonia 2.7Slovakia 3 Latvia 2.7Slovenia 3 Slovenia 2.7Scale:1-5.Source: EBRD Transition Report 2004.

EBRD index of enterprise reform EBRD index of competition policy

Domestic Demand PressuresDomestic Demand Pressures

Latvia: Contributions to GDP growth, 2000-20005q02 (1995 constant prices, in percent)

-10

-5

0

5

10

15

2000 2001 2002 2003 2004 2005q01 2005q02

Final consumption expediture Gross capital formation

Net Eports GDP

Source: Eurostat.

Simulation: Simulation: The Effect of Domestic Credit The Effect of Domestic Credit Growth Growth

Latvia: The Role of Composition of Domestic Credit (Cholesky 1 S.D. Innovations) 1/

Output Growth

-0.0018

-0.0013

-0.0008

-0.0003

0.0002

0.0007

0.0012

1 3 5 7 9 11 13 15 17 19

Output Growth

-0.0003

-0.0001

0.0001

0.0003

0.0005

0.0007

0.0009

0.0011

0.0013

1 3 5 7 9 11 13 15 17 19

Source: Fund staff calculations.

1/ The shock is to total domestic credit and total domestic credit minus deposits for each column correspondingly. Quarters on horizontal axes.

Inflation

-0.006

-0.005

-0.004

-0.003

-0.002

-0.001

0.000

0.001

0.002

1 3 5 7 9 11 13 15 17 19

Inflation

0.000

0.001

0.002

0.003

0.004

0.005

0.006

1 3 5 7 9 11 13 15 17 19

CA Balance

-0.003

-0.002

-0.001

0.001

0.002

0.003

0.004

0.005

0.006

1 3 5 7 9 11 13 15 17 19

CA Balance

-0.006

-0.005

-0.004

-0.003

-0.002

-0.001

0.001

1 3 5 7 9 11 13 15 17 19

Shock to Domestic Credit Shock to Domestic Credit Minus Deposits

Second-Round Effects Second-Round Effects ––Inflation ExpectationsInflation Expectations

Source: European Commision Business and Consumer Survey

High expectations

0

10

20

30

40

50

60

70

80

90

100

May

-01

Aug-0

1N

ov-0

1F

eb-0

2M

ay-0

2A

ug-0

2N

ov-0

2F

eb-0

3M

ay-0

3A

ug-0

3N

ov-0

3F

eb-0

4M

ay-0

4A

ug-0

4N

ov-0

4F

eb-0

5M

ay-0

5

EU EE LV LT HU

Low expectations

0

10

20

30

40

50

60

70

80

90

100

May

-01

Aug-0

1N

ov-0

1F

eb-0

2M

ay-0

2A

ug-0

2N

ov-0

2F

eb-0

3M

ay-0

3A

ug-0

3N

ov-0

3F

eb-0

4M

ay-0

4A

ug-0

4N

ov-0

4F

eb-0

5M

ay-0

5

EU CZ PL SI SK

Second-Round Effects Second-Round Effects – – Wage SettingWage Setting

Baltic States: Nominal wage developments (YoY change in percent)

0

2

4

6

8

10

12

14

16

18

2001 2002 2003 2004 2005Q1

EE LV LT

Second-Round Effects –Second-Round Effects –Wage SettingWage Setting

Baltic States: Real wage developments (YoY change in percent)

-2

0

2

4

6

8

10

12

2001 2002 2003 2004 2005Q1

EE LV LT

Source: CSO.

ConclusionsConclusions

Short-term supply factors and the catch-up to Short-term supply factors and the catch-up to EU levels may play a role in relatively high EU levels may play a role in relatively high inflation, as they do in other Baltic countries. inflation, as they do in other Baltic countries.

Demand pressuresDemand pressures – – compounded by compounded by structural factorsstructural factors – – contribute to inflation contribute to inflation inertia in Latvia.inertia in Latvia.

Even if inflation is driven by short-term supply Even if inflation is driven by short-term supply factors, there is a danger of secondfactors, there is a danger of second--round round effects as evidenced by recent wage hikes.effects as evidenced by recent wage hikes.

Possible Policy ResponsesPossible Policy Responses

Slow the growth of domestic demand, Slow the growth of domestic demand, mainly by cautious fiscal policy (save mainly by cautious fiscal policy (save revenue overperformance and keep revenue overperformance and keep expenditure/GDP constant)expenditure/GDP constant)..

Keep wage growth in check to avoid a Keep wage growth in check to avoid a wage-price spiral. wage-price spiral.

Improve competition, including at the Improve competition, including at the retail level.retail level.