Where has deflation gone?

Like the entire economy, the price domain has been bustling with activity of late. With domestic bubbles bursting and the global crisis persisting, belts have been tightened and wages and prices have gone down; as a result of Latvian commodities again becoming competitive, both internationally and domestically, the reliance on imports diminished. In the second half of 2009, price levels began to fall sharply, with both goods and service prices equally affected.  Nevertheless, a notable shrinkage in deflation surfaced almost one year after prices began to fall, and deflation is likely to turn into inflation during the nearest months. On the one hand, it is consistent with the forecasts about Latvia having no reason for falling deep into the deflationary spiral: regained competitiveness and fresh global price hikes would soon lead to a new, this time moderate price rise. On the other hand, however, the economic recovery is still fragile, while the rebound in prices is steeper than expected. This article briefly discusses why the deflation period is coming to an end so abruptly, whether the days of cost and price decreases underpinning the competitiveness are over, and whether radical rises in inflation are looming ahead.

Why has deflation decreased so steeply?

Deflation in Latvia has decreased mostly on account of external factors. Globally rising prices of natural resources fuelled respective price rises in Latvia as well, boosting input costs for a major part of goods and services.  A weaker euro translated into higher prices for imported goods, including energy resources, from non-euro area countries. The same factors have impacted the price dynamics also in the majority of Latvia's trade partners where inflation is already soaring, thus making Latvia's imports from these countries, primarily the EU, more expensive.

At this juncture, the price declines were most significantly offset by the rise in fuel prices and regulated energy prices. Due to global oil price hikes, fuel prices were climbing almost throughout the entire year, abating somewhat only during the concluding months. The tariffs of Latvijas Gāze, pegged to the global oil prices, increased sharply and also pushed up the heating tariffs to be faced by population with the onset of the heating season. In the current year, overall price increases of energy resources are expected to reduce deflation by a whole percentage point.

As weather conditions were unfavourable, global food prices grew as well. In Latvia, food price rises have been observed for quite a time now, and the sharp increase in vegetable prices alone reduced deflation by 0.4 percentage point. Purchase prices of milk and grain have recently gone up: it is beneficial for producers but disadvantageous for consumers because the prices for dairy products and bread edged up.

It is obvious that the price drop in Latvia has stemmed from and is still determined by the demand which is weakening due to shrinking income, yet there are several factors distorting this relationship.

First, the costs rising due to higher fuel and other resources prices make the local producers and service providers adjust their pricing policies.

Second, the so-called psychological factor is in place. In order to offset the falling income resulting from the contracting demand, a part of businesses opt for either the same price level or a higher one.   It is particularly true for goods of prime necessity, e.g. food and household goods, which are sold at points of sale, e.g. in distant rural areas, where there is no competition. There is another group of enterprises that, having previously raised the prices substantially, now opt to stand and wait for the demand to recover either maintaining their previous price levels or introducing temporary discounts.

Simultaneous price rises and falls

Notwithstanding the elevation of overall price levels over several consecutive months under the impact of the factors above, an ongoing decrease in prices of many commodities and services is also observed. In July, 62.2% of all consumer basket prices were below the level of the previous year; likewise month-on-month, more than a half of all goods and service prices (56%) did not change at all or dropped somewhat. Many enterprises keep enjoying the advantages of labour availability and lower labour costs resulting from high unemployment: it helps press down producer prices and attract customers in the circumstances of weak demand. Prices dropped for most services, transport vehicles and some food products.

Does sharply decreasing deflation imply the end of regaining competitiveness?

In Latvia, the price level has decreased to a lesser extent than expected previously; yet from the point of view of international competitiveness, the relative price and cost reduction is what matters.  If costs and prices in Latvia's trade partners decrease at a slower rate or soar more than in Latvia, our competitiveness improves. The elevation of resources prices and other external factors have pushed up production costs not only in Latvia but also in its trade partners.  At the same time vis-á-vis Latvia's many trade partners, labour costs shrink and productivity improves at a faster rate in Latvia. This distinctive dynamics implies that Latvia is gradually becoming more competitive. Export growth and expanding export market shares in many countries also testify to the country's improving international competitiveness. The real effective exchange rate of the lats has likewise decreased noticeably, suggesting improvements in cost competitiveness. As its calculation is based on comparable consumer and producer price data and relative labour costs, this rate is the reflection of changes in the relative cost and price dynamics.

What has the near future in store for us?

The impact of different, opposing factors with hard-to-assess overall effect on price changes is to be expected.  Uncertainty regarding the evolvement of global processes gives rise to different global energy-resources-related price expectations and concerns about the future of the European countries and the euro exchange rate dynamics. All these factors may exert influence, either upward or downward, on the prices in Latvia.

It is clear that the impact of the global food price rises is going to be felt thereafter.  At this point, the global energy prices are stabilising, and their pressure on price rises in Latvia will be less pronounced. With the heating season setting in, the consumption of other goods in Latvia could contract; consequently, due to eventually small demand, the prices could decline in those groups of commodities and services that are less affected by growing prices of resources. As business and consumer surveys cautiously assess the future perspective, there seems to be no reason for businesses to sharply push up the prices.

After the rebound in annual inflation, its upward trend is unlikely to be steep; meanwhile, the average price level in 2010 is expected to be behind that of the previous year.  

This article was published by Delfi on 7 September 2010.