Wednesday, October 21, 2009

Monetary Timelag In The Baltic States

One of the things that complicate understanding of inflation is the time lag between monetary inflation and price inflation, or in other words the time lag between money supply changes and price changes.

My good friend Daniel Halvarsson estimated based on U.S. data that the time lag to be 1-2 years. It should therefore not be surprising that price inflation is increasing even though money supply has been stagnant for the last few months. Last year inflation dropped faster than normal, but that reflected a sudden and sharp increase in money demand due to increased risk aversion after the Lehman crash. So under normal circumstances, 1-2 years seems like a good estimate.

The Baltic states, which experienced very high money supply growth during their boom, followed by a significant monetary deflation during the current bust, provide a good test of just how long the time lag is.

As I pointed out in my post "Rise And Fall Of The Baltic Boom", money supply growth peaked in early 2006 in Estonia and late 2006 in Latvia, but remained very during early 2007, particularly in Latvia. Money supply growth started to turn negative in early 2008, and has in recent months decreased at double digit percentage rates.

As a result of the high money supply growth during the boom, price inflation increased to very high levels, peaking during mid 2008 at roughly 12% in Estonia and 17% in Latvia.

Since then, price inflation has plummeted, to -1.7% in Estonia and 0.1% in Latvia. This is all the more impressive considering that both countries have increased their consumption taxes during this year. Inflation fell a lot faster in Estonia than in Latvia during late 2008, but has in recent months decreased a lot faster in Latvia, something which was related to the fact that money supply growth decelerated somewhat earlier in Estonia.

Depending on whether you connect the peak level in price inflation with the peak level in money supply growth or the end of the period of abnormal money supply growth, we can see that the time lag was 1½ to 2 years in Estonia and 1 to 2 years in Latvia. Between the shift to negative money supply growth and price deflation, the time lag was somewhat shorter, but still above 1 year.

Halvarsson's 1 to 2 year estimate seems to fit relatively well for the baltic states as well. While it shouldn't be seen as a "quantitative law" (as no such things exists except for purely functional ones), it does seem to describe how long the monetary time lag is in modern economies under normal circumstances.