Inflation and appreciation of Lek towards a new market equilibrium

The impact on inflation is dependent on the extent to which the country is dependent on imported raw materials and fuel and energy supplies.

The increase in Albanian inflation, being lower than in the trading partner countries, did not manage to significantly reduce the purchasing power of the Lek, nor did it weaken it against other strong currencies.

Indeed, in addition to the inflationary trend, there is also a strengthening trend of the lek, functioning as a channel through which external and internal shocks were transmitted to the economy.

While the Euro has weakened from January 2023 by 10.2%, the impact on average inflation for the same period has decreased by 2.5, through the reduction of import prices. This decrease of price curb comes as most goods are priced in Euros and other hard currencies. Now that the Lek is overvalued against the Euro, then the prices of energy and raw materials and imported goods have recorded lower costs in purchasing from imports.
As a result, we should have had an outward shift in short-run aggregate supply (SRAS). Consequently, this should create downward pressure on the overall price level at a higher rate than the current level.
The main obstacles to curbing the further reduction of inflation are mostly not of an economic nature. Most of the reasons are related to the informality and speculation of the import market and the market of domestic products. Informality is not affected by market supply and demand, as it follows its own rules. This prevents the transfer to the Albanian market of the full value of the costs reduced by the devaluation of the Euro, US. Dollar, etc. Also, the formal market tends to speculate on prices, taking advantage of the broken balance of market supply and demand.

This whole situation will continue in these trends as long as a new market equilibrium is not established based on what self-regulation of the market will bring, but which also requires fiscal intervention by the government regarding the control of informality, the circulation of dirty money and the policy of taxation with elastic and temporary rates for businesses that are correct with the implementation of the law and that have been influenced by the objective and subjective factors of the Albanian economy.

Meanwhile, as this balance still takes time to settle, a stronger Lek is making exports less competitive with prices in foreign markets. If export volumes shrink, the consequences will be a negative output gap and a decline in inflationary pressures that drag on demand. The state budget will begin to have a “firo” in planned taxes, as the impact on the economy and consumption will follow with a domino effect.

In the Albanian economy where the market is free and no prior agreement applies, the exchange rate is determined independently of the rate of economic growth. But the exchange rate will affect economic growth. Meanwhile, the rate of economic growth will be affected by the exchange rate. However, with many other variables at play, the two indicators have no direct correlation, but they still feel the gravitational influence on each other.

One present reason relates to the fact that currencies are valued against each other for a variety of reasons, including fiscal policy, interest rates, trade balances and business cycles.

A strong exchange rate is often considered to be a sign of economic strength. It can even become a symbol of national pride. Often politicians in advanced economies worry if they see a “weakening” exchange rate. They want to point to a strong exchange rate as a symbol of economic success.

Currencies are valued against each other for a variety of reasons, including fiscal policy, interest rates, trade balances, and business cycles.

A strong exchange rate is often considered to be a sign of economic strength. It can even become a symbol of national pride. Often politicians in advanced economies worry if they see a “weakening” exchange rate. They want to point to a strong exchange rate as a symbol of economic success.

Eventually, a strong (appreciating) exchange rate tends to occur in countries with low inflation, improving competitiveness and strong economic performance. However, this situation does not apply to the Albanian economy, which has both elements in operation, since the Albanian economy does not yet stand out for its important level of competitiveness and does not have a significant impact on the circulation chain of regional and European products.

In the short term, a strong exchange rate may be due to several other factors. Short-term movements in the exchange rate can be misleading about the overall economic situation because it can be driven by speculation rather than long-term economic improvement, but they create uncertainties that transmit volatility to consumption and exports, including foreign and domestic tourists.

In this trajectory an overvalued exchange rate causes lower economic growth because exports become uncompetitive, and consumption is shocked. This, if the fiscal agencies do not react with increased intensity, may affect the weakening of favorable positions for tax revenues.

Although in the Albanian monetary environment a high exchange rate seems to be an anti-inflation tool, this is a small good compared to the evils listed above. To the extent that the relationship is reliable for the triangle of increased lending interest rates, the impact on inflation and the exchange rate, there seems to be a stronger willingness to keep the value of the Lek high, which reduces the inflationary consequences of an expansion of given the money supply.

In this situation, we think it is possible that an exchange rate appreciation could make the Central Bank more willing to cut interest rates, which in turn could increase inflationary pressures to pull back demand.

Meanwhile, the Ministry of Finance and Economy, in coordination and updating of the Agreements for free and open trade, should now review the possibility of an anti-dumping scenario for goods and jurisdictions that affect competition with Albanian exporters and products.

Currently, after several months of Lek appreciation, this exchange rate is becoming a critical issue of concern given the poor real performance of the Lek against major trading currencies such as the US dollar, Euro, and British pound. Further, business and consumers are believing that the exchange rate has the power to influence domestic market policies, as the performance of the exchange rate can translate into price volatility in the Albanian economy, particularly dependent on imports for daily expenses.