1. Inflation Increase in Latvia: A Short-Term Phenomenon or a Risk Associated with Demand Pressure? Christoph B. Rosenberg Senior Regional Representative International Monetary Fund Warsaw Regional Office

2. Latvia's Inflation in Perspective * Baltics and EU8 exclude Latvia. Source: Eurostat.

3. The SDR Peg and Inflation (a)

4. The SDR Peg and Inflation (b) Notes: NEER weights assume that imports from EU are priced in Euro, non-EU imports priced in dollars. Contributions to HICP estimated using weights based on imports to GDP ratios in each country. * Jul-Dec Source: Eurostat.

5. Supply-Side Effects Source: National authorities.

6. Catch-Up to EU Price Levels (a) Relative price level vs. relative GDP per capita (PPP), 1995-2004 Source: Eurostat.

7. Catch-Up to EU Price Levels (b) Source: Eurostat.

8. Structural Factors

9. Domestic Demand Pressures Source: Eurostat.

10. Simulation: The Effect of Domestic Credit Growth

11. Second-Round Effects – Inflation Expectations

12. Second-Round Effects – Wage Setting

13. Source: CSO.

14. Conclusions Short-term supply factors and the catch-up to EU levels may play a role in relatively high inflation, as they do in other Baltic countries. Short-term supply factors and the catch-up to EU levels may play a role in relatively high inflation, as they do in other Baltic countries. Demand pressures – compounded by structural factors – contribute to inflation inertia in Latvia. Demand pressures – compounded by structural factors – contribute to inflation inertia in Latvia. Even if inflation is driven by short-term supply factors, there is a danger of second-round effects as evidenced by recent wage hikes. Even if inflation is driven by short-term supply factors, there is a danger of second-round effects as evidenced by recent wage hikes.

15. Possible Policy Responses Slow the growth of domestic demand, mainly by cautious fiscal policy (save revenue overperformance and keep expenditure/GDP constant). Slow the growth of domestic demand, mainly by cautious fiscal policy (save revenue overperformance and keep expenditure/GDP constant). Keep wage growth in check to avoid a wage- price spiral. Keep wage growth in check to avoid a wage- price spiral. Improve competition, including at the retail level. Improve competition, including at the retail level.