Stagflation in Latvia: How Long, How Far, How Deep

Posted on September 1, 2008 | SSE Riga/BICEPS Neregulāra rakstura raksti

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

Executive summary

What a difference a year makes. Our previous report, from June 2007, focussed on overheating of the Latvian economy and rising inflation. Now, some 14 months later, the Latvian economy has entered recession as measured by two consecutive quarters of seasonally adjusted GDP decline. At the same time the latest inflation rate is down from the peak observed in May of this year.

Thus the issues to be discussed in this year’s report are somewhat different. In particular we raise five questions – questions we believe should be at the forefront of the economic-political debate in Latvia:

  1. Has inflation indeed spiked?
  2. Is disinflation (i.e. the rate of decline in inflation) likely to be fast or slow?
  3. Why has the Latvian inflation experience been so much worse than elsewhere e.g. the two other Baltic countries?
  4. How deep a recession – permitting the use of that concept – will Latvia experience?
  5. How long will it take for the economy to recover?

We offer the following responses to these questions:

  1. It is likely that inflation has indeed peaked – the slowdown of the economy and thus the unwinding of overheating in the labour market should suffice for that conclusion.
  2. The evidence from our Phillips curve analysis, i.e. the inverse link between the rate of inflation and the unemployment rate, together with the flexibility of the Latvian labour market points in the direction of a fast disinflation, while evidence from other countries emphasises the persistence of inflation. However, it needs to be borne in mind that the Phillips curve analysis also predicts that lower inflation will come at the cost of higher unemployment.
  3. A much more overheated labour market in Latvia and perhaps belated policy response are to blame for the worse performance in Latvia.
  4.  and 5. Evidence from international experience suggests that the cumulative loss from a recession might be the equivalent of two years of double digit GDP growth relative to trend. Instead of growing 10-11% as was the norm until 2008 negative growth – recession – is on the cards. This loss of potential GDP is a setback for the prospects of Latvian convergence. The Latvian economy may be expected to resume normal growth in 2010.