The year was characterised by declining economic growth and accelerating inflation

Märten Ross
Deputy Governor of Eesti Pank

In Estonia's economy, the ending year marks the beginning of the softening of economic growth that has been accelerating since the accession to the European Union. Given Eesti Pank's forecast a year ago, this should not come as a surprise. Investment growth has reached its peak and together with that, the economic growth will also begin to slow. The deceleration has turned out to be even faster than expected, although its causes are consistent with the forecast. However, the positive side of it all is that the foreign trade deficit decreased also faster than expected.

Inflationary pressure was also stronger than expected. The temporarily faster price rise was influenced by accelerated wage growth, tax changes that were greater than planned, and the unfavourable development of world market prices. For many, the most important issue of the year was not the decelerating economic growth but rather the accelerating inflation. Probably, the relatively intense end of the year emotions regarding the preservation of the kroon were also partly caused by that.

Estonia's current monetary system has been in place for more than fifteen years. It has given us a low inflation rate and a good basis for controlling future price expectations. Yet, it is natural that when inflation increases temporarily above the average level of several years (as was the case this year), people will start to question the capability of the state's monetary system to control the inflation also in the future.

I would like to remind you, however, that in the first full year of the kroon, the price rise was 90 per cent. Only ten years ago, the inflation rate was more than 11 per cent. In the following period, the annual growth of the average price of the consumer basket decreased already below 10 percent and in 2002-2003 was exceptionally even lower than in the eurozone.

Price rise concerns mainly services

In the last couple of years, inflation has been fluctuating between 4 and 6 per cent. When a couple of years ago the price rise was accelerated mainly by energy prices, then in recent times the main determinant has been the services sector (including construction services). An unpleasant surprise this year was the rapid growth of food prices towards the end of the year. Consequently, inflation fluctuated as high as between 6 and 9 per cent in the second half of 2007.

Containing inflation by fixed exchange rate is actually rather simple. When the kroon is pegged to the euro, the economy "imports" the low inflation rate of the euro zone through trade also to us. This is so mainly due to the fact that a small economy like Estonia has to import many of the goods. In the case of domestic goods, the local manufacturer also needs to keep in mind that when the price is too high, foreign competitors will take his place in the market by putting downward pressure on the prices.

Thus, when the increase in the price of goods is moderate in Europe, it is moderate also in Estonia. For example, if the prices of mobile phones or cars decrease in the world, then due to the fixed exchange rate they will also decrease in Estonia.

However, inflation cannot be associated only with cross border trade of goods. It is more complicated to contain the prices of services, as their cross border competition is generally not as strong as in the case of goods. Of course, this does not apply to all services. Some services, such as flights, are highly dependent on international competition. On the other hand, street cleaning or the production of drinking water cannot be organised from abroad.

The prices of services are more closely related to wages. Wage is quite an important factor influencing the price of a hair cut or piano lessons. Therefore, the prices of such services depend considerably on labour market developments. If wages grow fast, as was the case in Estonia after the opening of the labour market (particularly in 2006-2007), it will certainly have a great impact on the prices of many services.

For a small country like Estonia, the basis for wage formation is the competitiveness of exporting companies. In addition to manufacturing companies, this includes service providers that sell their services also to abroad, such as Skype or Tallink.

If exporting companies are more productive and able to earn higher profits, it enables to increase the wages of their employees as well. However, in terms of the total economy the labour market is a single unit, and thus the wages of other companies will also form this way. Therefore, if the competitiveness of the exporting sector weakens, it means lower wage growth in the whole economy and not only in those enterprises. This, in turn, will entail lower price growth in the services sector.

Adding the two aspects - goods and wages - we see the whole picture of how the fixed exchange rate and the currency board ensure a low inflation rate. The prices of goods follow the developments in the world market, whereas the prices of services are in line with income growth, which, in turn, should not exceed the growth of productivity in the exporting sector.

In Estonia, such process is clearly observable. Namely, the prices of services have grown faster, whereas the price growth of industrial goods has been limited. It is obvious that the accelerating inflation is closely related to the wage increases. It has been influenced by the improving competitiveness of Estonian exporters and a greater confidence of households with regard to succeeding in the European labour market. However, these factors began to withdraw already in 2007 and along with the slowing growth the inflation rate will also decrease in 2008-2009.

Inflation targeting is the same also in the eurozone countries, for instance in Finland and Ireland. Maintaining the overall price stability in the eurozone is a different story. In such a large and relatively closed economic system there is no point in seeking for an external anchor to constrain the price rise. The euro itself is this cornerstone and low inflation is ensured by the European Central Bank by curbing domestic demand through the interest rates.

Low CPI is not the goal

So what would be the normal inflation rate for Estonia? There is no one and only possible indicator. If the wage level in Estonia was the average in the European Union and the productivity and wages grew broadly at the same pace, Estonia's natural inflation rate could then be the average price rise in the Monetary Union; that is around two per cent.

Yet, it is clear that while Estonia's productivity and wages are approaching the general level of Europe, the inflation will also be higher. Consequently, it is not possible or even wise to say that the inflation rate of a country that is in such a development phase like Estonia should necessarily be, for example, 2.35 per cent. If Estonia's economy is capable of growing by 6 per cent in 5 years compared to Europe's 3 per cent growth, then its inflation rate is expected to be 4.5 per cent compared to Europe's 2 per cent rate. If the productivity growth is slower or faster, the inflation rate will naturally differ. If the exchange rate is fixed or if the country belongs to the Monetary Union, then such inflation resulting from the productivity growth is inevitable and natural.

If we do not like our inflation indicator, we must first answer the question of whether the wage growth reflects the extensive changes in economy and the improvement of long term competitiveness or not. We should be worried about the inflation rate only when we doubt in that.

Of course, the above should not be construed as a justification for a higher inflation rate. It is of utmost importance that the activities of central banks would be aimed at preserving a low long term inflation rate. Joining the eurozone would mean greater certainty for Estonia in respect of containing inflation in the long term.

In the short term, the inflation rate can also be influenced by the changes in the taxation of goods or services. If the state imposes a higher excise tax on beer, then it is likely that the price of beer will increase somewhat. It is also likely that at first this will lead to a higher price level compared to the one before raising the excise tax.

In a longer perspective, increased taxes do not affect the general price level. If people now spend more money on drinking beer, they will have fewer resources for other kinds of entertainment. Hypothetically, we might say that beer will be relatively more expensive and massage will be relatively cheaper.

The state has options

It is clear that the sharp rise in the excise tax at the beginning of 2008 increased also the inflation forecast for that year. However, such budget balancing will not boost inflation in the future; quite the contrary - it will hold back the fears that through the budget deficit, the state will support the growth of demand. In other words, such measure may actually curb the long term inflation expectations. This, by the way, was also reflected in Eesti Pank's autumn forecast where the growth of excise taxes indeed increased the estimated inflation for 2008 but decreased the outlook of price growth expected for 2009.

Many have asked whether the state has no additional opportunities for inflation control. In overall terms, one could say so, but this should not be over-dramatised. If we want to get from point A to point B by train, we cannot drive a car at the same time. If the strategy of the monetary policy is the approach based on a fixed exchange rate, there is no point in complaining or regretting that the opportunities of the other option are left unused.

Still, a couple of things should be pointed out that the state can do so that the inflation pressure would last for a shorter period and the economy would cope with it better.

First, such legislation and activities that prevent the normal functioning of the labour market and goods market should be avoided. Free trade and a wage formation that reflects the changes in productivity are extremely important in inflation containing. In addition, free enterprise and combating monopolistic practices are vital.

Second, it must be kept in mind that the state itself is a major user of resources. The state's own demand affects, at least temporarily, the wage levels of the public sector and, for example, the construction prices. Therefore, it is essential that the wages of civil servants would also reflect the changes in our competitiveness.

Third, in the upward phase of the economic growth in particular, it should be borne in mind that raising the expectations for future too high may create favourable preconditions for a temporary hike in the inflation rate. Yet, the election campaign this year sinned against that a great deal.

In conclusion, it can be said that although growing inflation witnessed this year was unpleasant for many, its underlying causes were absolutely logical and programmed into the previous economic peaks. Yet it must be reminded once again that when these shocks pass, our monetary system that is based on the fixed exchange rate will automatically slow the inflation.

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