Disinflation: A Tough Battle
- By Peter Westin
- Aug. 12 2003 00:00
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Oil prices remain the key swing factor for inflation. We estimate that a $1 change in the average oil price changes Russia's annual inflation by 0.3 percent. For instance, at an average for Urals Mediterranean Blend of $27 per barrel for the year -- which equals the average in the first seven months of this year -- inflation would finish at 13.3 percent. Similarly, a lower average oil price would relieve inflationary pressure; for example, a $17 per barrel price level would produce inflation of 10.3 percent. Our current forecast of 12.7 percent for the year is based on an estimated average price of $25 per barrel.
It is clear at this stage that the main culprit for inflation pressure is the high oil price. The inflow of capital, mainly in the form of export revenues, has increased liquidity in the economy. The strong buildup of international reserves is caused by the Central Bank soaking up dollars by printing rubles. The monetary base has so far this year increased almost 24 percent and is up 43 percent over the last 12 months.
However, the inflationary impact of the current oil-driven monetary expansion is mitigated somewhat by unorthodox sterilization mechanisms, including increased ruble demand among the population and an increased willingness to hold rubles as a store of value. In addition, there is paradoxically one positive aspect of Russia having an underdeveloped banking system, namely that the system takes money out of the economy but fails to channel liquidity back into the economy, which is reflected by the low level of bank lending to the private sector. It has to be said, however, that this positive aspect is far outweighed by all the negative aspects associated with the lack of financial sector reform.
Russia is still in the process of adjusting its relative price and wage structure. The price of essential services, which include housing and natural monopoly tariffs, has been the major inflationary driver outside of oil. The government is seeking to control these by limiting natural monopoly tariff hikes to a few percentage points above the forecast consumer price index. Concerning wages, officially they have risen 129 percent in the last three years compared to 74 percent CPI growth, which has increased demand-driven inflationary pressure. The pending State Duma elections in December, as well as the presidential election in March, means that wages are set to continue to increase this year and next. So far this year, wages are up 25 percent year-on-year, and in October state sector workers are looking to get a 33 percent wage hike. The administration then will face the task of honoring election promises, increasing the likelihood of further wage increases in 2004.
The Central Bank, as well as the government, remains sure that it will be able to meet the inflation target of 10 percent to 12 percent for 2003. For the last five years, the Central Bank and government have set an annual inflation target and then missed it -- although they have consistently reduced inflation since 1998. These constant misses hurt the Central Bank's credibility, and it also remains unclear just who is responsible, the government or the Central Bank, for ensuring that inflation comes within the target. Therefore, a policy set to reduce inflation, without a specific target, may be a preferable strategy in the short run. In other countries, a zealous inflation target has been more successful in keeping inflation low when there is single-digit inflation, and has been less successful when inflation is in the double digits. According to a recent study by the IMF, 40 countries are currently aiming for lower and stable inflation but only 18 are classified as fully fledged inflation targeters (which does not include Russia), all of which adopted inflation targeting after inflation had been brought down to single digits.
Nevertheless, an annual inflation rate slightly above the Central Bank and government target of 12 percent does not necessarily stifle growth. Although it is clear that galloping inflation is harmful, research has not convincingly proven that mild inflation is damaging. In fact, several Central and East European countries (including Russia in the last couple of years) have managed to produce strong growth under mild inflation.
To bring inflation down, the factors of luck, timing (initial conditions), and political institutions have proven to be most important in determining a successful disinflationary policy. Current conditions, with a fiscal surplus and high international reserves, do provide Russia with good economic conditions. However, keeping in mind that Russia is still confronted with a need for structural changes, it is likely that inflation will fall at a slow pace in the next couple of years. In fact, current policies seem to be unable to accommodate an inflation target policy. The main deflation policy mechanism is the limitation of natural monopoly tariff increases. However, a relatively loose monetary policy is set to continue in the current climate of high oil prices (and reserves buildup), in combination with the continuing process of re-monetizing the economy. If an inflation target policy were to be pursued, it would be more appropriate to set a long-term, realistic target instead of the current short-term fudge the Central Bank and the government insist on setting.
Peter Westin is a senior economist at Aton Capital. He contributed this comment to The Moscow Times.