IBNA Analysis/ the Supervisory Council deems that achieving the inflation target in the medium term will require maintaining the eased monetary conditions over some quarters ahead
By the Supervisory Council of the Bank of Albania
The Supervisory Council of the Bank of Albania reviewed and approved yesterday the Quarterly Monetary Policy Report. Based on the latest monetary and economic developments in Albania, and following the discussions on their outlook, the Supervisory Council decided to lower the key interest rate by 0.25 percentage points, to 2.0%. The Supervisory Council deems that the key interest lowering provides adequate conditions to support economic growth and the return of inflation to target within a medium-tem period.
In the second half of 2014, the Albanian economy improved, but overall inflationary pressures remained weak and inflation continued to stand below Bank of Albania’s target. Although upward, aggregate demand is still insufficient to ensure complete utilisation of production capacities in the economy and generate stable growth of employment, wages, profit margins and final prices in the economy. Supply-side factors, such as imported and primary commodity prices, and the performance of inflationary expectations continued to provide low pressures on consumer prices. In the fourth quarter, as a result of a fall in imported inflation, the trajectories of economic growth and inflation diverged.
The overall economic environment, characterised by weak inflationary pressures, below-potential economic growth, and high risk premiums in the financial market dictated the implementation of an accommodative monetary policy during the last quarters. The accommodative policy further strengthened during the period, through the lowering of the key interest rate, the provision of forward guidance on maintaining the simulating monetary policy in the future, and the continued injection of liquidity into the banking system. In response to this simulating policy, financial markets were characterised by interest rates trending downward. Financing costs of the banking system and interest rates on lek loans fell to their historic low in the quarter under review. In response to the monetary policy transmission, the performance of lek loans improved in the last two quarters of 2014. However, the full transmission of monetary policy into the economy continues to suffer from the businesses’ reluctance to engage in long-term investments and the banking system’s risk aversion.
Economic growth in the third quarter of 2014 and its assessments for the fourth quarter were on up side of our expectations. By contrast, inflation performed on the down side of our projections in the fourth quarter of 2014. Although our medium-term forecasts did not change considerably, in the short-run, the expected performance of economic growth has shifted upward, whereas that of inflation has shifted downward. The Supervisory Council deems that the current and expected developments in the economy reiterate the need for pursuing a stimulating monetary policy. Medium-term forecasts and return of inflation to target remain conditioned by the recovery of private consumption and investments. Under these circumstances, the Supervisory Council deemed it necessary to lower the key interest rate further, down to 2.0%. This move provides adequate conditions for the return of inflation to target and of the economy to equilibrium in the medium-term horizon.
Following is an analytic overview of current and expected economic developments, and a more comprehensive discussion on the monetary policy.
Inflation in December 2014 stood at 0.7%, falling sharply dictated by the low rise in food items and the continuing decline in oil price. The latter lowered further the production and transport costs in goods and services. From a macroeconomic standpoint, the sluggish aggregate demand continued to determine the low inflation rates. The strong deceleration of inflation over the last quarter of 2014 seems to be mostly attributable to the fall in imported inflation. The external environment of the economy exerted disinflationary pressures on the Albanian economy, a trend expected to persist in 2015 as well.
Our projections suggest that inflation will rise gradually, converging to our target of 3% in the medium term. This result remains subject to our projections for a rapid return of the economy to equilibrium. Economic growth is expected to strengthen and the labour market and wages to improve. Imported inflation is expected to remain sluggish over the medium term, whereas inflation expectations are expected to shift gradually towards Bank of Albania’s target.
The economy performed in line with our expectations in the second half of 2014. Real value added by sectors of the economy recorded an annual increase of 3.3% in the third quarter of 2014, accelerating compared to growth recorded in the first and second quarters. Sectorial structure of production growth was balanced, as shown by the increasing positive contribution by both services and production sectors. Indirect available data suggest that economic growth continued over the fourth quarter of 2014. Based on these assessments, the Bank of Albania expects a progressive improvement of economic growth in the period 2014-2016.
On the expenditure side, economic growth was mainly driven by consumer spending and less by private and public sector investments. The improved confidence in the economy, low interest rates and credit expansion, increased employment and the payment of arrears by the public sector are estimated to have supported private sector spending in the last quarters. Our estimations suggest this performance will continue in the future.
External demand was sluggish and the exchange of goods and services with our trading partners provided a net negative contribution of 3.8 percentage points to economic growth in the third quarter of 2014. Real net exports deficit expanded by 18% in the third quarter of 2014. This performance reflects the slow increase in Albanian exports, compared to a faster increase in imports. From a macroeconomic perspective, the slow increase in exports reflects the sluggish demand by our trading partners, as well as supply-side shocks in some sectors of production. On the other hand, the increase in imports mostly reflects the improvements in domestic consumption and investments. For the last quarter of 2014, our projections point to a minimum negative contribution of real net exports to aggregate demand.
Fiscal policy was consolidating during 2014. This policy was manifested in the contraction of the budget deficit, which mainly reflected the rapid growth in revenues. Budget deficit in the first 11 months of 2014 amounted to ALL 41.3 billion, or 35.1% lower than the planned level for this period, and 31.9% lower than in the previous year. As of November, public revenues grew by 12.6% in annual terms, whereas total expenditures increased by about 5% in annual terms. Despite the consolidating nature, fiscal adjustment was uneven throughout the year. This adjustment was concentrated in the first half of year, being considerably loose in the third quarter; the fourth quarter is estimated to have produced a positive fiscal stimulus. The Bank of Albania continues to support fiscal consolidation. The improved sustainability of public finances lowers risk premiums in the economy. It provides conditions for the implementation of a more simulating monetary policy and increases the effectiveness of its transmission to the economy.
Reflecting on projections for low inflationary pressures and the presence of unutilised production capacities in the economy, the Bank of Albania lowered the key interest rate by 0.25 percentage points in November 2014. That was the third move towards easing the monetary conditions during 2014. The monetary stimulus contributed to lowering interest rates and improving financing conditions in the economy. Meanwhile, government borrowing costs increased slightly due to demand-supply disequilibrium in this market. Interest rates applied on loans to the private sector trended downward throughout the year, reflecting the improved growth paces of loans in the second half of 2014. At the end of November, annual credit growth stood at 3.8%, from 1.6% at the end of the third quarter of 2014. In response to Bank of Albania’s accommodative monetary policy, lek loans recorded 9.3% annual growth in November, revealing a much better performance than foreign currency loans. Notwithstanding the improved tendencies, lending continues to remain sluggish due to supply and demand-related problems. On the demand side, below-potential economic growth and real-sector uncertainties make businesses postpone their investment plans and financing demands. On the supply side, credit performance is negatively affected by: the high level of non-performing loans, which burden banking system’s balance sheets; the high risk premiums in specific sectors of the economy, which render these sectors less attractive for crediting; and the conservative policies implemented by parent banks, which impose tight crediting policies in Albania. Bank of Albania’s analyses and projections suggest that lending will recover slowly during 2015.
Our macroeconomic projections point to the closure of the negative output gap and a gradual return of inflation to target in the medium-term period. In the baseline scenario, annual inflation is expected to range within 1.2 – 3.8% four quarters ahead, with a 90% probability of occurrence, and to return to Bank of Albania’s target of 3% in the medium term. The gradual return of inflation to target will be driven by economic growth and its return to equilibrium.
The above scenario is surrounded by risks, of which we would like to highlight the following:
Firstly, the European external economic and financial environment remains challenging. In this regard, banks’ risk appetite and willingness to lend to the private and public sectors in the Eastern European countries, including Albania, appears still low. A further deterioration of this outlook would require implementing further corrective measures and searching for new financing sources.
Secondly, our forecasts are largely subject to expected improvements in consumption and private investments. Through the easing of financing standards in the economy, the monetary policy creates adequate conditions to stimulate them. However, the steady growth of consumption and investments will depend on the further improvement of the business climate and the deepening of structural reforms, which boost productivity in the economy and enhance the effectiveness of the monetary policy.
Based on the available information, the Supervisory Council of the Bank of Albania decided to lower the key interest rate by 0.25 percentage points, to 2.00%. The transmission of this decision into the financial markets will create adequate monetary conditions to support economic growth and the return of inflation to target. Moreover, based on baseline scenario projections, the Supervisory Council deems that achieving the inflation target in the medium term will require maintaining the eased monetary conditions over some quarters ahead.