The National Bank of Georgia operates under inflation targeting framework that implies the announcement of the inflation target for the medium term. The main objective of the NBG – price stability – does not imply 0% inflation, but rather inflation level of 3% during 2019-2021.
The target level of inflation is determined by the current state of the Georgian economy and reflects the increases of prices that will be optimal at the current level of economic development. When defining the optimal level of inflation, the Monetary Policy Committee considers various factors. Firstly, they take into account the fact that the prices of the various products included in the consumer basket do not change proportionally – some increase, while others might decrease. So the reduction of inflation to 0% would mean a price decrease on some goods and services. Therefore, a positive inflation target avoids the risk of deflation and its negative effects on the whole economy to be overcome.
It should be noted that the CPI is characterized by several biases and overestimates the inflation level, which can be explained by the following:
• Substitution bias: the CPI measures changes in price levels indirectly, relying on the basket of goods and services consumed by an average consumer. It cannot incorporate the tendency of consumers to purchase inexpensive substitutes for expensive items when prices change.
• Quality Bias: the quality of goods and services improves over time, which leads to price increases. The CPI does not reflect inflation attributed to quality changes.
• New product Bias: new products permanently enter the market and substitute old ones, however they are incorporated into the index with some time lag. Thus, the price decrease associated with new products is not reflected in the index right away.
When defining the target level of inflation, the country’s growth rate and productivity changes in the tradable and non-tradable sectors are also considered. In general, developing countries have a higher growth rate of productivity than advanced countries, especially when it comes to the tradable goods sector. As a result of labor force mobility, wage increases that accompany productivity growth in the tradable sector also cause salaries to increase in the non-tradable sector (even if the productivity in the non-tradable sector remains unchanged). Ultimately, the economy gets increased salaries and prices. It can thus be concluded that the higher the growth rate of productivity in the economy (especially in the tradable sector) compared with other countries, the higher the inflation rate. According to rough estimations, in Georgia inflation attributed to the higher growth of productivity in the tradable sector (compared with the non-tradable sector) is 2%. As productivity growth slows down, the National Bank of Georgia will gradually decrease the inflation target. In the long-run, the desired level of inflation is defined at 3%.
The monetary policy of the National Bank of Georgia is forward looking and is based, not on the current level of inflation, but rather on the forecasted level of inflation and the expectations of economic agents. For this reason, economic conditions are constantly evaluated and inflation forecasts are developed which account risks that can influence the price level. If expected inflation is above the target, the National Bank of Georgia tightens its monetary policy by increasing the monetary policy rate. In case of lower expected inflation, the NBG conducts an expansionary monetary policy by decreasing the monetary policy rate.