III
INFLATION

Estonia's inflation is in the long term determined by price convergence, caused by changes in the economic structure and the productivity growth exceeding that of industrial countries. Price convergence approaching the level of developed countries has had its ups and downs. Due to external shocks and the following adjustment period, prices grew very slowly at the end of 1998 and in the first half of 1999.

Several price indicators hit the lowest in the first quarter. Thus, the export-import prices reached the bottom in January and producer prices in May (see Figure 3.1). In the third quarter prices were exposed to a larger external demand than before, the growing exchange rate of the dollar and the completion of the domestic adjustment process. All these factors more enhanced than inhibited the price increase. In the last months of 1999 and in 2000 price increases should recover due to economic revival.

CONSUMER PRICES

Traditionally consumer prices grow little in summer. In the third quarter there was no significant change and the annual price increase dropped to 2.7%. The bottom was reached in July-August; beginning from September the inflation pace has been growing and dependant on the fourth quarter developments the annual average consumer price growth will remain within 3.2-3.3%.

The price increase minimum in the open sector was in the third quarter when prices decreased by 0.6% (see Figure 3.2). The domestic adjustment process facilitating price decline was more or less completed in the third quarter as the supply of several foodstuffs fell significantly. Foodstuffs were 3.5% cheaper than a year ago; milk production had decreased 12% and meat production 10%. Since autumn, the reduced supply of milk pushed purchase prices significantly up.

The external environment did not have any further price decreasing impact in the third quarter. Open sector prices were subject to the appreciation of motor fuel caused by significant increases in raw oil prices as well as by the appreciation of the dollar.

Price increase in the sheltered sector has stabilised at an annualised 10% during the last eighteen months, linked mainly to increases in administered prices. In the third quarter, the price growth reached an annualised 10.2% in the sheltered sector, too. Whereas the most significant growth agent was the appreciation of telephone services.

In 1999 the discrepancy between the price growth in the open and sheltered sectors has exceeded ten percentage points. Such a large discrepancy refers to the lack of incentive for the sheltered sector to adjust itself to the changing conditions in the environment of economic recession and falling profits. This is also proved by the larger-than-average growth of salaries and staff in some undertakings sheltered from external competition.

OTHER PRICES

Unlike consumer prices, import, producer and export prices maintained the upward trend in the third quarter, although only import prices have reached the level of 1998 with annual growth reaching 1.4%. Both the exchange rate of the dollar and appreciation of raw materials have had their impact here. The latter has been encouraged by the revival of world economic developments. Export prices grew by 0.4% in the third quarter, providing a 1.2% decrease over the year. Trade has been in an unfavourable environment during the last year, with import prices growing faster than export prices. This can be explained by the trade structure in which external shock had an impact on export prices.

The real exchange rate of the Estonian kroon, following the devaluation of the Russian rouble last August, has remained on the same level or even depreciated (see Figure 3.3). In September, the annual rate change became negative both against the currencies of industrial countries and transition economies. In the latter case the single leap took place in September of 1998 whereas the annual change in the real exchange rate of the kroon against the currencies of industrial countries dropped to the lowest level ever during nine months of 1999, being only 2.9%. Both the decline of the nominal exchange rate of the kroon against the US dollar and slowing down of Estonian inflation has had their impacts here. Thus, the developments in the real exchange rate of the kroon have been rather favourable for Estonia's foreign trade.