The monetary easing cycle in Poland is not over
Arkadiusz Krześniak is chief economist at Deutsche Bank Polska
It's the beginning of the summer holiday season, and a good time to reflect on the further course of monetary policy in Poland. The central bank, in a series of six consecutive moves of 25 basis point cuts each, lowered the main intervention rate from 6.75 percent in December 2002 to 5.25 percent in June 2003, reducing the real interest rate level from 6.25 percent to 4.55 percent. In a press interview recently, NBP President Leszek Balcerowicz stated that, due to the cumulative effects of past rate cuts and an accelerating economy, room for further rate cuts was limited. Moreover, there is mounting evidence that fiscal policy will be looser in 2004 than it was in 2002, and looser than had been planned for 2003. The fiscal deficit in 2004 could reach zł. 50 billion-zł. 55 billion (5.8 percent-6.4 percent of GDP) under 2003 definitions , or zł. 38 billion-zł. 42 billion (4.4 percent-4.9 percent of GDP) under the EU's definition. Will this fiscal loosening affect the central bank's monetary policy? One factor of uncertainty will be the behavior of the new Monetary Policy Council (RPP) that will be conducting activities starting in February 2004.
First, uncertainty over the effects of past rate cuts makes monetary policy a difficult task, but past evidence shows that the RPP tended to undershoot policy targets in 2001-2002. This can help in times of high inflation, as it contributes to faster decrease in the consumer price index (CPI), but it can be a drawback when inflation is low. So judging by past evidence (which cannot, of course, be treated as a prophecy of future performance), monetary policy is likely to be still too cautious, rather than stimulating, by the year's end. Consequently, the risks of lower than expected inflation overshadow the risks of higher than expected inflation, suggesting that past tight monetary policy has left room for rate cuts in the near term.
Second, one can agree that the domestic economy is recovering, albeit at a slow pace. Does this recovery pose any threats to price stability? The current growth rate, 2.2 percent year-on-year in the first quarter and an estimated 2.4 percent in the second quarter, is still well below the potential growth rate of 4 percent-5 percent per annum. Growing at half of its potential growth rate, the economy cannot experience demand-driven increases in price levels. In fact, the prices of 10 percent of the goods in the consumer basket (including food prices, which account for 38 percent of the basket) are lower than a year ago. Polish consumers have experienced a mild deflation of 1 percent-2 percent year-on-year in several demand-sensitive consumer goods (shoes, clothing and household appliances, for example). The only risk to price stability stems from oil prices, but as the złoty weakened by 6.3 percent in the first half of 2003, the depreciation alone is enough to prevent a further significant decline in oil prices. Negative supply shocks, such as a surge in oil prices, are likely to only temporarily increase price levels, while dampening GDP growth at the same time, and past experience shows us that monetary policy is not effective in dealing with supply shocks. So, on the inflation front, there are few risks to price stability and the ones that do exist are potential rather than actual.
Third, does fiscal policy create a risk of inflation? In general, expansionary fiscal policy implemented when an economy is nearing its peak may create additional upward pressure on price levels. But what the Polish economy is experiencing now is a phase of inflation-less cyclical recovery, and capital utilization is still very low. In this phase of the business cycle, fiscal policy usually acts as an automatic stabilizer, as periods of lower economic growth coincide with a higher fiscal deficit. 2004 will be somewhat different, as EU-related costs to the budget will amount to zł. 7 billion-zł. 7.5 billion (€1.57 billion-€1.68 billion), and lower revenues from the corporate income tax (CIT), reduced by some zł. 4.5 billion (€1.01 billion) as a result of a lowered CIT rate, would add about zł. 12 billion (€2.69 billion) to the budget deficit, bringing it to the zł. 50 billion-zł. 55 billion (€11.2 billion-€11.3 billion) level. EU-related costs certainly will not increase inflation, as they will be transferred abroad. The inflationary effect of a reduction in the CIT rate will be negligible, as this fiscal stimulus of 0.5 percent of GDP most likely will translate into increased investment demand, which is currently depressed, or into corporate savings, which are neutral to inflation. Thus the total effect of a fiscal loosening in 2004 on inflation will be very limited.
Fourth, will the new RPP create a danger to price stability? Most likely not. New RPP members will be aiming at earning credibility from the market, so we shouldn't expect a revolutionary change in the conduct of monetary policy. Quick entry to the euro zone will remain the main goal of the central bank, with the caveat that there will be less stress placed on achieving nominal convergence now as opposed to, say, 2007 or 2008. The new RPP, in its first months, is likely to cut interest rates by a total 50 basis points. Poland will experience only a slight increase in inflation, to 1.2 percent year-on-year in December 2003, allowing the current RPP to cut interest rates by 75 to 100 basis points by the year's end, resulting in a 4.25 percent-4.5 percent intervention rate in December 2003, and a 3.75 percent-4 percent intervention rate in twelve months' time.
