The CBRT needs support in ensuring quantitative tightening. Otherwise the new policy framework will further be questioned.

Last week two important indicators were announced. The data was quite favorable: a marked decrease in inflation and a striking increase in production. I will try to evaluate these developments in the context of the Central Bank's (CBT) new policy framework.

In 2010 inflation was realized at 6.4 percent in line with the target. In January, inflation rate stood at 4.9 percent quite below the 2010 realization. Headline inflation indicator (I index) that the CBT attaches importance to increased from 3.0 at the end of 2010 to 3.2 percent in January. This is significantly below the 2010 inflation which was 5 percent.

In December 2010 industrial production increased by 16.7 percent year-on-year. Net of seasonal and calendar effects, industrial production demonstrated a 5.7 percent month-on-month increase. This is a striking and impressive gain in production. 

Wheat prices hike
Therefore, the negative impact of the crisis on industrial production was overcame. The peak level of industrial production before the crisis was achieved in March 2008. The level in December is 5.1 percent higher than the peak. This has also pushed up the growth expectations for 2010, 9 percent growth rate is being pronounced now.

These all are favorable developments. However, when they are read in the context of the new policy framework of the CBT, some potential problems appear. Rapid increase in production indicates that output gap has been narrowing. This is an unfavorable development considering the future path of inflation. Some other indicators that have an effect on inflation rate also give negative signals. Wheat prices hike throughout the world. Price of the crude oil varies around $90 per barrel. Over the last month exchange rate also increased significantly.

Let me remind you that under the new monetary policy framework the CBT at the end of the last two board meetings announced that interest rates were cut. The mentioned negative developments with respect to the future course of inflation becoming visible following the interest rate cuts might reinforce the anxiety of the CBT. 

Additional measures needed
I have discussed the contradiction posed by the new policy framework several times at this column. In order to overcome this, the BRSA and the political authority had to implement additional measures, I said.  Given that the new policy framework must be supported with additional decisions, which is absent yet, it would not be for the benefit of the CBT if the circumstances require a raise in interest rate.

The CBT needs to enjoy a time interval where the possibility and necessity of raising interest rates is not discussed. Should signals that inflation can move up come, the step the CBT probably takes will be drawing attention to the headline inflation and emphasize that inflation rate is in line with the medium term targets.

But this 'defense mechanism' is problematic under the current circumstances. For the headline inflation that stands at a low level to imply that the core inflation will tend downwards in the future, the difference between the two must be float slightly above and below zero. But since 2006 the latter have been ranging above the headline inflation: not floating but moving in a single direction.

The CBT needs support in ensuring quantitative tightening. Otherwise the new policy framework will further be questioned.

This commentary was published in Radilkal daily on 10.02.2011