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Inflation continues to noticeably and negatively affect the national economies and the welfare of each of us in the last couple of years. It increasingly becomes a big social problem. 

On July 15, Prime Minister Ali Asadov signed a decree, thereby creating a working group supposed to reduce inflation to levels acceptable for Azerbaijan's economic growth. The decree underlines the need to improve the monitoring system to enable the analysis and assessment of ongoing processes and their causes, as well as to strengthen inter-agency cooperation in this area.

Meanwhile, the Central Bank (CBA) is optimistic about the inflation rate by the end of this year and kept its interest rate at 9%.

Not there yet

The participants of the first meeting of the working group discussed the issues that require more in-depth study of prices by types of goods and services in the consumer basket, including changes in price indices of agricultural and industrial producers, etc.

According to CBA, annual inflation continues to decline and stopped at 10.6% in June, which is 5 percentage points (pp) below the peak level of recent years recorded in September 2022. At the same time, deflation of 0.9% was registered in June compared to the previous month. Annual food inflation fell to 11.5%.

Positive trends are mainly a result of declining consumer price index (CPI) in partner countries and in the world commodity markets. Thus, the average inflation in Azerbaijan's trading partners in June 2023 decreased more than twice compared to the peak indicator observed in October 2022. CBA notes that this is mainly due to the weakening of global economic activity, lower world energy prices and tight monetary policies in most countries.

"5.6% of the annual inflation rate (10.6% ) in June was due to imported inflation, which clearly shows the dependence of these processes on external factors," CBA Chairman Taleh Kazimov said at the recent press conference. He admitted that in import-dependent countries the impact of the discount rate was small.

International Monetary Fund forecasts that global inflation will fall from last year's 8.7% to 7% in 2023. IMF Managing Director Kristalina Georgieva expressed particular concern about higher food and fertiliser prices, calling on G20 countries to build up financial cushions to support disinflation.

"There is some progress, but we are not there yet. The course of monetary policy needs to be maintained. Premature celebrations can undo the hard-won gains in disinflation," Georgieva said.

According to the World Bank's latest Commodity Markets Report, commodity prices fell 37.1% year-on-year in June; energy prices fell 45.1% and non-energy prices fell 15.1%. According to the UN Food and Agriculture Organisation (FAO), food prices fell by 20.9% in June.

The Asian Development Bank July report "Asian Development Outlook: Sustained Growth with Controlled Inflation" indicates that inflation in the Caucasus and Central Asia region will remain at 10.6% in 2023 and 7.8% in 2024, up from 10.3% and 7.5%, respectively, in the April report.

Internal tools

CBA believes that the consumer price index in Azerbaijan will reach single-digit 6-7% by the end of 2023, with GDP growth of 1%. At the same time, non-oil GDP growth rate will be 3-4%. Expectations for next year look more optimistic: GDP growth 4-5%, non-oil GDP growth 5-6%.

Is it realistic? According to Vusal Gasimly, Executive Director of the Centre for Analysis of Economic Reforms and Communications, the actual GDP in the non-oil sector of Azerbaijan is higher than the potential one. In other words, the economy is warmed up, with a positive production deficit in the non-oil sector. "This indicates that there is more demand for goods and services than the economy can produce at the maximum sustainable level. Aggregate demand is expanding with government support. Aggregate supply should therefore respond to this demand so that inflation is balanced," Gasimly said.

CBA can regulate this process by influencing aggregate demand rather than aggregate supply. For example, the main inflationary factor of aggregate supply is imports, which increased by more than 20% in the first five months of 2023, while CBA's ability to directly influence inflationary imports is limited.

What is the structure of the aggregate demand? It is mainly private consumption and private investment, as well as government spending. CBA can influence these processes by raising interest rates. The average interest rate on 1-3-day operations in the interbank unsecured money market has increased by 2.67 pp since September 2022 and by 1.72 pp since the beginning of this year as a reaction to changes in the interest rate.

Another indicator of ongoing processes is the AZIR index (Azerbaijan Interbank Rate), reflecting the average interest rate on transactions between banks concluded in national currency on Bloomberg trading floor. Since the beginning of this year, the one-day and weekly indicators of the AZIR index have increased by 1.87pp and 1.04pp, respectively. The growth of this index raises interest rates on loans issued by banks, hence reducing demand for them. Fewer loans means less money in the economy, which starts cooling down.

Still risky

According to the CBA chairman, inflationary pressure reduces the balance in the foreign exchange market, particularly strengthening the nominal effective exchange rate of the nationaly currency, manat. "A 10% strengthening of the nominal effective exchange rate leads to a 3.4% fall in inflation. 10.3% strengthening was recorded in the first half of the year. Together with a trade surplus of $9.8b in the last half year, this had a positive impact on the consumer price index," Kazimov said. This was a result of the trade balance surplus, while non-oil exports increased by 21.8%.

In order to regulate the money supply more effectively, further limit the liquidity of the banking system and support the de-dollarisation trends, CBA revised the rule of differentiation of reserve requirements. Thus, from July 2023 all banks must calculate mandatory reserves according to the new norms and maintain them accordingly from August 15. "Differential introduction of mandatory reserve norms depending on the size of legal entities' deposits will reduce liquidity concentration and sterilisation of additional funds," Mr. Kazimov believes.

But despite the positive mood, there are risks. CBA recognises that the risks are quite high, especially in terms of price growth in trading partners. For example, in Türkiye, inflation is forecasted at 58%, although it has slowed down to 38.2% in annual terms in the last six months. Chairman of the Turkish Central Bank, Hafiza Gaye Erkan, promised that the bank would gradually tighten monetary policy to improve the indicators. "We will continue to apply all financial instruments until we reach single-digit inflation," she said, noting that they were taking measures to lay the groundwork for the disinflation process to begin in 2024.

As for Azerbaijan, CBA has taken a pause in tightening monetary policy, but further decisions will depend on the situation with CPI. According to some experts, by the end of the year it is possible to reduce the interest rate by 0.5%. But it will be prices and inflation that decide everything in this context.