Good news on prices, but...

Last November, Finance Minister John Dalli reaffirmed, in his budget speech, that one of the highest priorities in the government's economic agenda is a low and stable inflation rate.

He expected inflation in 2003 to remain in line with that in 2002 at 2.5 per cent, though it would seem that the actual rise in consumer prices last year was nearer 2.96 per cent.

Price stability is a key parameter in achieving sustainable economic growth. Markets can allocate resources more efficiently if price stability is maintained, while investment decisions can be taken on the intrinsic merits of a project rather than on speculation as to how prices and production costs will move over time.

On the other hand, high and unpredictable rates of inflation erode the purchasing power of incomes and hit hardest the weakest members of society.

It was therefore welcome news to read that the headline inflation rate (that is, the 12-month moving average) in March continued its downward slide and now stands at 1.46 per cent, an impressive 60 per cent less than the peak rate of 3.65 per cent registered in April 2002.

Moreover, the year-on-year increase in the Retail Price Index (RPI), which is a good indicator of inflationary pressures, dropped from 4.5 per cent in March 2002 to 0.5 per cent in March 2003.

Analysis of the figures released by the National Statistics Office recently reveals that, while the 12-month moving average inflation rates for most sub-indices of the RPI increased during 2002 and only the clothing and footwear sub-index registered a drop, the trends in the first quarter of this year have changed.

Substantial drops in the prices of clothing and footwear items continue to influence heavily the overall index, but we are now seeing declines in the prices of other items, such as household equipment, transport and communications, no doubt in some measure due to the removal of remaining levies on industrial products in January.

Of some worry is the fact that, while food prices declined in 2002, they now seen to have resumed an upward trend. In fact, while in the first quarter of 2002 food prices fell 25 per cent, they increased by 1.6 per cent in the first quarter of this year. The higher excise tax on tobacco will also have contributed to the five per cent rise in the beverages and tobacco sub-index.

Malta's major trading partners within the European Union and its competitors in the other EU accession countries all maintain a strong policy focus on low inflation. In the 10 acceding countries, a limited rebound in inflation is expected, with average inflation reaching 3.3 per cent in 2003, after 2.9 per cent in 2002. Yet, this increase is small and mostly explained by the cyclical recovery and some one-off adjustments of administered or regulated prices.

In many countries, the underlying trend of disinflation is partly offset by hikes in administered prices and Customs tariffs, driven by the need to align the regimes to the acquis communautaire and to reduce state aids in important areas. This will temporarily weigh on aggregate inflation rates in a number of countries.

Adjustments in the excise rates in 2003 and 2004 in the framework of tax harmonisation with the EU, as well as removal of operational aid to certain industries, will surely have some adverse impact on the price level in Malta. On the other hand, further liberalisation in various sectors of the economy and the positive effects of restructuring in certain enterprises, as well as eventual downward pressure on the prices of some tradeable goods and services after May 2004, should alleviate the upward pressure on prices.

With an economy that is wide open to external influences, it follows that imported inflation, which is determined by the interaction of inflation in Malta's trading partners and exchange rate movements, is another important factor in the price environment in Malta. Inflation in the eurozone rose at a rate of 2.3 per cent in the first quarter of this year while the euro has appreciated by 5.5 per cent against the Maltese lira. This must have fed through to higher prices in Malta.

At a time of intense global competition, safeguarding price competitiveness is a policy imperative for Malta. The Central Bank has pursued price stability by pegging the Maltese lira to a basket of low inflation currencies, namely the euro (70 per cent), the US dollar (10 per cent) and the sterling (20 per cent). Experience suggests that the fixed exchange rate regime has delivered good results. In fact, domestic inflation has tended to remain within a reasonable range of the average inflation rate in the countries represented in the currency basket. Over the past five years it has averaged 2.4 per cent, departing only minimally from the basket-weighted foreign inflation rate.

However, the Central Bank's monetary policy cannot, on its own, be expected to deliver miracles. The fiscal policy adopted by the other key policy-maker, namely the government, also has a tremendous bearing on the desired price stability. This is because budget deficits and debt exceeding certain levels generate inflation expectations, putting upward pressures on interest rates.

It is therefore quite worrying that, according to recently-released provisional statistics from the NSO, the structural deficit in 2002 was some Lm10 million higher than budgeted, while that in the first quarter of this year was a whopping Lm25.8 milllion higher than the same quarter last year. The public debt in 2002 was Lm118.5 million more than budgeted in November 2001, while the debt in the first quarter of the year was Lm88 million higher than in last year's same quarter.

This confirms that pressures over expenditure remain, keeping the deficit relatively high. One can reasonably expect the deficit to come under further pressure from health and education outlays, the compensation scheme for the removal of agricultural import levies, the restructuring programme for the shipyards and costs related to the implementation of the EU acquis.

Consequently, while the latest RPI figures are good news, they are tinged by continuing concern about the state of the public finances and their negative impact on the outlook for future price stability.