III INFLATION

The long-term change in Estonia's price level depends still on the price convergence, related to the general developments and trends of the economy (see Monetary Developments & Policy Survey. Eesti Pank, Tallinn, 1998, pp 21-25). Due to the cumulative impact of various short-term factors, the actual inflation could significantly differ from the trend.

In the first half of 1998, two different sets of factors designed inflation. At the beginning of the year inevitable administrative adjustment, concentrated into a short timeframe, prevailed in the general price increase. In the second quarter mainly market forces were responsible for changes in the price level. It brought along a leap upward (in December 1997 the 12 months price increase was 12.5%, in January 1998 - 14.2%), followed by a quick drop (in June 1998 the 12 months price increase was 10.2%). Although the inflation has not yet reached the March 1997 lowest figure, when the 12 months price increase was 9.1%, there are several signs of a potential price slowdown (see Figure 3.1).

According to all indicators, the price increase in the first half of 1998, was below that of 1997. The most drastic change took place in export prices and producer prices which the 12 months price increase decreased from 4.7% and 8.6% in January 1998 to 1.9% and 4.0%, respectively, in June (in energy production and mining from 17% down to 4.5%). The disinflation in administered prices was also remarkable - the 12 months price increase was 20.2% in January and 12.1% in June. The construction price index has decreased the least - 0.4% (see Figure 3.2).

One of the main changes in inflation factors is probably the stabilization of the nominal exchange rate of the kroon against tradable currencies. In 1997, the kroon depreciated against the tradable currency basket by 7.5%, but after some fluctuation during the first quarter of 1998, the trend has been opposite. Import prices which in the first quarter were slightly growing, but fell to the level of the beginning of the year by June, support postregulatory rapid reduction in the inflation growth rate (see Figure 3.3).

Extensive price adjustments in January were partially a coincidence, although it seems becoming routine that main regulations take place at the turn of the year. Such a timing has a simplifying effect on state budget and firms revenue forecasting. In the first half of 1998, most price increase after-effects became evident in the first quarter. Once more it became clear that the price adjustment would bring along a one-time acceleration of the price increase and therefore it would be impossible to forecast further trends. It is confirmed by the declining inflation over the next months.

Interest rates increase starting in the second half of 1997 and the following shrinkage of credit opportunities has continued this year, too. Economic environment suggest changes in profit statements and in cost structure. The impact of the financial environment on the inflation rate has been reversed compared to the past, ie from promoting price increase into reducing. The Stabilization Reserve Fund as well as tighter supervision measures for commercial banks have had their impact, too. Liquidity restrictions dampening the loan growth, tougher regulatory requirements for banks and interest rate growth suggest easing demand pressure. The above is backed by statistics, revealing shrinking ending increase.

A significant change has taken place in the growth rate differences of producer and consumer price indices. In 1996 and 1997, the consumer and producer price indices difference was on the average 0.4 percentage points per month, but in the first half of 1998 - 0.6 percentage points. It can be explained by an increasing competition in the open sector and changes in the nominal exchange rate of the kroon against the US dollar which would, first and foremost, affect producer prices and less consumer prices.

Apart from developments on the money market, it is possible to identify some other factors inspired by changed demand-supply ratio in commodity markets. It applies, first and foremost, to foodstuff industry which is closely related to the eastern market. Its unstable foreign trade policy has made the above sector more vulnerable. The ban on dairy products export to the European Union has reduced foreign demand in the west as well. Increasing domestic supply has lowered prices in the domestic market below the regular level.

The 12 months growth of the real effective exchange rate (REER) of the kroon decreased between January and June 1998 to 7.7%, being still above 5.2% in December 1997 as the inflation growth in the first quarter of 1998 in Estonia exceeded that of our major trade partners (see Figure 3.4). In August 1997, the 12 months REER growth rate was the lowest ever but since then it has been accelerating due to the strengthening of the kroon as well as the faster disinflation in other transition economies.

In the first half of 1998, Estonia's price level increased by 5.1% against its foreign trade partners. About 0.9% of the increase could be explained by decreasing nominal exchange rates of foreign currencies. Against developed industrial countries these indicators are 5.5 and 0.4%, respectively. About half of the 4.4% price level appreciation against transition economies was caused by the depreciation of the nominal exchange rates.

The above indicators cannot be simply transposed to international competitiveness. Firstly, price changes are better described by the producer price index. The latter based REER computations provide a significantly lower difference between trade partners and Estonia's general price level. The 12 months consumer price based REER increase was 7.7% in June whereas producer price based REER increase was only 4.5%.

On the other hand, competitiveness of goods depends on other factors beyond prices - productivity growth, relative labour cost, market share, administrative constraints (duties, quotas), etc. As in any transition economy, it is difficult to assess changes in the productivity. We use an indirect indicator, often applied in transition economies - the ratio of the real economic growth to the real exchange rate change of the kroon (see Figure 3.5). According to this indicator Estonia's international competitiveness has not changed since 1996. Actually it means improved competitiveness as computations evolve REER based on the CPI.