Monetary Policy Report, July 2019 - Brief Overview
In the second quarter of 2019, the annual inflation rate, as it was expected, stood higher than the target level and equaled 4.4%. However, the increase from the beginning of this year was slightly higher than forecast, caused by higherthan-expected prices of tobacco products and certain components of food category. Nevertheless, as it was expected, this upward pressure on inflation from one-off factors and intermediate cost of servicing foreign currency loans was partly offset by the downward pressure from aggregate demand. As a result, annual inflation in June retreated slightly and stood at 4.3%. Even though this indicator is still higher than the target level of 3%, in the absence of the contribution of excise taxes on tobacco products (1.3 percentage points), inflation would have been very close to its target level.
According to the National Bank of Georgia’s forecast, inflation will remain somewhat above the target level of 3% in the short-run, but will decline below it by the next year due to weak demand. In the medium term, however, it will still return to the 3% target level (see Figure 1). Specifically, according to the forecast, on the back of excise taxes on tobacco products and recent depreciation of the domestic currency, annual inflation will remain higher than the target level in the short-run. However, since this depreciation is a reflection of an expectation of external demand weakening, the weak demand will, on the other hand, have a downward pressure on inflation in the medium term. Finally, as the aggregate demand increases to its potential level, it is expected that annual inflation will reach the target from below by the end of the forecast horizon.
In the first quarter of 2019, real GDP growth was 4.9%, while, in the second quarter, according to the preliminary data, it stood at 5%. Despite rising risks in the recent period, relatively high economic growth in the first half of 2019 was mostly driven by stronger external demand. However, notwithstanding activated fiscal spending and moderate growth of loans, growth of consumption and investment was weak. Thus, similar to the previous Monetary Policy Report, the downside risks to real GDP growth are still well visible.
Due to the external shocks, the NBG reduced real GDP growth forecast for 2019 and 2020, which now stands at 4.5% (see Figure 2). While credit growth and the size of fiscal deficit carried more risk in the previous quarter, external sector replaced them in the current period. The baseline scenario is based on the assumption that Russian sanctions on air travel to Georgia, through tourist sector, will reduce external demand by 300 million US dollars. Despite that, according to the forecast, net export will still contribute positively in GDP growth, even though the effect is expected to be modest. The reason of net export still having a positive contribution to growth is an important improvement in the current account in the first half of 2019. In addition, on the back of moderate credit growth and budget expenditures, consumption and investment will also contribute positively through the forecast horizon. According to the revised estimates, the deviation of economic activity from the potential level (which, according to the current estimates, is around -1%) will widen slightly in the short-run. However, it is expected that, the output gap will then continue improvement starting next year and will close in 2021.
The main goal of the National Bank of Georgia is price stability, which means inflation close to its target level in the medium term.
It should be noted that monetary policy cannot aim to fully neutralize temporary factors affecting the inflation rate in the short run. That objective could only be reached through policy changes, which might lead to extreme fluctuations in economic growth and employment. Therefore, the National Bank of Georgia tries to strike a balance in its decision making, considering the expected timeframe over which the inflation rate will return to the target level and estimating the possible effects on economic growth.
Despite higher-than-target inflation, the current macroeconomic forecast envisages a downward trend for the monetary policy rate in the medium term (see Figure 3). There are several reasons for that. First of all, baseline scenario assumes that, despite high uncertainty in the recent period, Georgia’s risk premium will not increase significantly. In addition, current nominal effective exchange rate seems to be undervalued more than the size of the current external shock
would suggest. Hence, the possible appreciation of the nominal effective exchange rate is expected to exert a downward pressure on inflation. Secondly, expected weakening of external and, hence, aggregate demand next year, together with an expiration of one-off factors, will significantly slow down the price increases. The forecast is also based on the assumption that the budget deficit and credit growth will not be higher than currently expected. The optimal response of the monetary policy to this is to determine such a policy rate trajectory that guarantees inflation being close to the target. According to the baseline forecast, the policy rate will decline to its neutral level, which, according to the current estimates, is 5.5-6%, after 1-2 years. However, if the upward pressure on inflation stemming from the exchange rate will persist, then the Committee will consider the possibility of the monetary policy tightening.
It should be stressed that the monetary policy rate forecast is not a commitment to future decisions made by the National Bank of Georgia. Rather, it is the expected trajectory of the policy rate assuming that all exogenous factors incorporated into the forecast materialize as expected.
The forecasts depend on exogenous factors and contain risks in both upward and downward directions. In terms of external factors, risks are mainly associated with the economic growth of Georgia’s main trading partners, the global trends of the euro and US dollar, and international prices of oil and food. In terms of domestic factors, risks stem from changes to the fiscal deficit, credit activity and business sentiment. Hence, if external and/or domestic factors evolve differently than is currently expected, this may influence macroeconomic variables and, consequently, will affect future decisions made by the National Bank of Georgia.
