Counting on Oil
Sept 28, 2006
Oliver Weeks (London)
The Slovak National Bank’s latest 25bp rate hike, on a 5-3 vote, was above market expectations (no change) and below our expectation (50bp). The National Bank’s statement was relatively cautious, pointing to “strong wage growth”, “weakening productivity growth” and “a further gradual monetary tightening”. With new macro forecasts due in October, a further 25bp hike to 5.0% looks likely then, but with energy prices moving favourably and headline inflation poised to dip sharply in October, the bank may then choose to rest on its fortunately won laurels. Whether this will be enough to make euro entry in 2009 realistic now depends significantly on whether oil price falls continue, in our view.
Core inflation should rise further but headline should fall. Demand pressure on inflation indeed remains significant. Core inflation has continued to creep up, with the National Bank’s core HICP measure excluding energy and unprocessed food reaching 2.6%Y in August. The volatile monthly wage series was revised up in July, with nominal wage growth at 8.3%Y in July and showing signs of adjusting to temporarily high headline inflation. Nevertheless, we think that headline inflation likely peaked in August, less a result of monetary policy than the plunge in world energy prices and the government’s efforts to force energy companies to reduce their margins. The (nominally independent) regulator has said it will decide by the end of this month on October’s gas price hike, but the rise will be less than the 8.7% requested by SPP, already sharply reduced from 15%, and far below the 20.3% rise in October 2005. The government is pushing for no hike at all in October, and cuts in water and energy prices in January. The Hungarian-owned Slovnaft has already cut petrol prices around 12% since early August. A likely cut in VAT on pharmaceuticals in January should also help to massage inflation downwards. We expect headline inflation to dip to around 4.4%Y in October and 3.6%Y in January. Oil may make Maastricht inflation criterion achievable. More importantly, in the medium term, falling energy prices, if sustained, will significantly reduce the current account deficit. Net energy imports in 1H were 8.0% of GDP (against 5.8% in Hungary, 4.6% in the Czech Republic and 2.2% in Poland) with an average Urals price of US$64. Urals oil is already down 13% on these levels, and a sustained fall in Brent prices to Morgan Stanley’s medium-term US$50 forecast could alone take around 2% of GDP off the Slovak current account deficit. Together with the ongoing pick-up in car exports, this would do much to compensate for slower FDI inflows and cancelled privatisation. Further SKK strength would do much to restrain the rise in core inflation. Meanwhile, falling energy prices would see headline inflation falling below core. The huge imbalance in the weights of energy in the HICP basket between Slovakia and the EU-25 (19.0% and 9.4%, respectively) makes lower energy prices asymmetrically favourable for Slovakia in terms of meeting the Maastricht inflation criterion. This level currently stands at 2.8%Y, and downward pressure from energy may be counterbalanced by the likely acceleration of Polish inflation, currently one of the EU’s bottom three reference rates. Oil and budget remain risks. Clearly, relying on more oil price falls is a risky strategy for the National Bank. More aggressive rate hikes would still be justified, in our view, given the importance of the euro entry target and the unpredictability of the oil market. However, given the cautious pace of rate rises when Urals was at US$65 and CPI seemed likely to reach 5.5%, it seems hard to expect a more aggressive stance with falling headline CPI. The bank’s most recent medium-term forecasts assume Brent oil averaging US$69.6 in 2006 and US$73.6 in 2007. Equally, fiscal policy remains a risk both to inflation and euro qualification. Details on the 2007 budget remain thin and highly unconvincing, with a wide range of spending increases promised to pensioners, parents, teachers, doctors and farmers, costed by Smer at 1.2% of GDP. The government claims that lower tax thresholds and cuts in administrative spending can still achieve the tightening needed (around 0.9% of GDP, on our estimates). We find this improbable, but with the inflation target looking more achievable, we can no longer exclude the government deciding to tighten fiscal policy further. With oil prices rising, we could see little sense in taking unpopular measures to meet the fiscal criterion when the inflation criterion would exclude Slovakia anyway. If oil falls further, the government could wisely decide to seize an opportunity that may not be repeated for some time — to likely discomfort in Brussels and Frankfurt.
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