Inflation in Latvia: Causes, Prospects and Consequences

New SSE Riga/BICEPS occasional paper by Morten Hansen (SSE Riga) and Alf Vanags (BICEPS).

Abstract. This report is the second in an annual series produced by BICEPS and SSE Riga on macro policy issues. The 2007 report is again on inflation but this time focusing only on Latvia. The inflation problem in Latvia has not gone away and if anything has intensified since early 2006 to the extent that the Latvian government was forced into action to set up a working group on inflation which eventually published an anti-inflation plan in early March 2007. The aims of the 2007 report include: to examine the most recent developments in consumer prices in Latvia and link them to developments in producer prices and wages and to make an assessment of the likely future course of inflation in Latvia; to propose and outline a framework for analysing macroeconomic policymaking in Latvia; and to examine the likely impact or effectiveness of the anti-inflation plan.

While it is well known that consumer inflation has been rising again in early 2007, reaching a 10 year high of 8.9% in April, the report draws attention to the accelerating pace of both wages (32.8% growth in the first quarter of 2007) and producer prices (which have been rising at between 16% and 18% in early 2007). We see wage growth as feeding into producer prices after a lag of approximately 15 months and this in turn feeds into export prices entailing a loss of competitiveness. The analysis of price and wage developments suggests that the inflation problem cannot be addressed separately from the imbalances in the labour market and neither can it be addressed separately from the imbalance in the external sector. Moreover, the recent surges in producer prices and wages point to further inflation in the pipeline and to the possibility that the Latvian economy has shifted from a position of simple overheating to something more serious in structural terms.

The analysis of inflation as such is followed by a proposed framework for policy analysis based upon the classic economic policy work of Tinbergen and its application to open economy macroeconomics by Swan. The Swan diagram is used to characterise Latvia’s economic policy problem in terms of internal and external balance. Evidence is provided on recent developments in export and import volumes as well as on real effective exchange rates which suggests the rapid emergence of a severe external imbalance. Since the internal situation is universally acknowledged as characterised by excess inflation Latvia is firmly located in the Deficit/Inflation zone of the Swan diagram and moreover with an uncompetitive real exchange rate.

Applying the Swan diagram framework to the government anti-inflation plan reveals that all the main proposed measures are equivalent to fiscal measures. This has the consequence that the plan can only generate a larger or smaller contraction of domestic demand depending on the severity of the fiscal contraction. This in turn means implementing the plan cannot simultaneously achieve acceptable inflation and growth together with external balance. Thus Latvia remains on the horns of a Tinbergen policy dilemma – by choosing to remain on the existing peg to the euro it has too few instruments to achieve its policy targets. Through a policy of ‘neglect’ the government has arrived at a situation where all realistic options will be painful.