This report examines the inflation experience of the EU new member states (NMS) since 2000, with particular focus on the three Baltic countries – Estonia, Latvia and Lithuania. Apart from being a natural focus of interest for residents of these countries it appears that their recent inflation experience – accelerating inflation in all three, with Latvia and Estonia posting the two highest NMS inflation rates in 2005 – marks them out from the other NMS. Indeed Latvia is the now the country with the highest inflation rate in all of the EU. At the same time the actual levels of inflation are different across the three Baltic countries. So the central questions addressed in the report concern the reasons behind the acceleration of inflation in the Baltic states when such an acceleration has not been observed in the other NMS and how to reconcile the ‘common Baltic acceleration’ with the observation that levels of inflation in the three countries remain different.
A key message of the report is that there is no mystery about the Baltic inflation experience in recent years – all is explainable in terms of fairly standard and well supported economic principles. This is true of both the inflation differential between the three Baltic countries and of the common acceleration. It is concluded that the inflation differential is largely explainable by the decision of the central banks of the three countries in the 1990s to peg their national currencies to different international units. Estonia pegged to the D-mark and then to the euro, Lithuania to the US dollar, and Latvia to the SDR basket of currencies. As a consequence the rather large movements in the euro/dollar exchange rate observed over 1999-2005 had very different price impacts in the three countries. As for the common inflation acceleration, developments in all the key economic indicators – growth, unemployment, credit, and wages – all point in the direction of economies that are seriously overheated.
Our detailed examination of inflation experience across countries points to a diversity of experience but a diversity that is also largely explainable in terms of economic analysis. Thus where underlying economic developments (eg growth) have implied the need for an adjustment in the real exchange rate vis-à-vis the euro this has been effected more by nominal exchange rate changes in countries where there has been a floating rate (Poland or the Czech Republic) and by changes in the domestic price level where the exchange rate has been pegged (the Baltic countries).
For Baltic governments who are pondering policy actions to reduce inflation the message is clear – if there is a serious intention to reduce inflation, then domestic demand needs to be reduced and if monetary policy is not available because of the constraint of pegged exchange rates then fiscal instruments must be used ie higher taxes or public lower expenditure or both. It will be painful – growth will decline, unemployment will rise and perhaps the property boom will collapse – but it will work.