Märten Ross. Coping with inflationary pressures

The Central & Eastern European Forum, 15-16 January 2008, Vienna

Coping with Inflationary Pressures

Märten Ross

I will focus my remarks on issues of price convergence and monetary stability, and especially how price convergence and inflation play out in a country with a fixed exchange rate regime like Estonia. 

The main reasons behind the relatively high inflation (in Estonia) in 2006-2008 are integration and convergence. It would be strange to push for integration in labour, product and financial markets on the one hand, while hoping that broad differences in price levels of assets, goods and labour persist on the other hand.

Floaters have "hidden" that partly behind the nominal appreciation of their currencies. But the overall real exchange rate, i.e. price level developments, is both similar and logical in all the new Member States. So, did we really expect EU accession to have no effect at all on equilibrium real exchange rate levels?

All in all, as this development reflects inevitable changes in relative prices, a more adequate question is: "How to cope with restructuring?"

Turning again to inflation, the above means that first we need to have our targets right. It is totally out of line to discuss the challenges of getting inflation as low as the euro-area level for those countries who keep a credible fixed exchange rate as a long-term anchor for monetary stability.

In this context, the fixed exchange rate has been performing pretty well as a means of price stability control, since compared to other regimes, price level convergence has been less volatile and tradables prices quite stable.

Therefore, the principal policy issue is not to achieve a specific inflation level in the short term. The main task is to help economic agents to make right choices in the difficult process of relative price changes and to minimize negative consequences of possible wrong decisions. Again, stabilising tradables prices via a strong fixing has been a very important and successful tool here.

Of course, some economic policy aspects are important as well

a.  Definitely, it is good to have countercyclical fiscal policies; but they do not have necessarily a direct impact on inflation in the short term. However, strong fiscal stance is essential to provide stable framework for less benign periods.
b.  It is of great importance to work for better product and labour market flexibility and integration. Again - this might not have a short-term effect on inflation, but it would provide a better link between productivity, income and thereby price level;

In Estonia, the strongest effect of EU accession has already worked through the asset market as well as the labour market. The domestic elements of inflation have probably also peaked. However, global market prices as well as heavy agenda of indirect tax increases in Estonia will postpone a steeper decline in 12-month headline inflation data to the second half of 2008.

Märten Ross. Coping with inflationary pressures