Central Bank of Armenia: Rising unemployment and low inflation are  the result of weak aggregate demand

ArmInfo.The Board of the Central Bank of Armenia believes that a lower refinancing rate is necessary to achieve the inflation target of 4% in the medium term and ensure price stability. In this context, on September 10, the Central Bank once again reduced the key rate by 0.25 percentage points - from 7.75% to 7.5%.

The rationale for this decision was  presented today at a press conference by CB RA Chairman Martyn  Galstyan. He noted: "We were able to cope with high inflation ahead  of time, which made it possible to begin easing monetary conditions  earlier. Our surveys showed that expectations of high inflation have  decreased and expectations of low inflation have increased, but at  the same time the uncertainty component remains high. As for GDP  growth, according to the Central Bank's assessment, the gap with  potential is narrowing, while still remaining at a positive level."  He noted that in the third quarter of 2024, annual inflation  continued to remain below the target threshold, registering 1.3% in  August. Core annual inflation also remained at low levels, at 0.3%  year-over-year in July".

At the same time, he stated that in Q3 2024, risks of slowing  economic growth globally and in the key trading partner countries of  Armenia continue to persist. "Global inflation continues to decline.  However, sticky prices in key trading partner economies continue to  remain relatively elevated. Since the beginning of the year,  persistent geopolitical uncertainties in the Middle East, as well as  growing tensions in international trade relations, continue to create  certain risks for future growth in global commodity prices and  possible disruption of global supply chains. At the same time, recent  slowing in key trading partner countries' labor markets could point  to some softening in demand conditions. In this context, key trading  partner central banks would be expected to begin gradually ease the  policy rate in the near term, while still maintaining a relatively  tight stance," Galstyan explained, adding that as a result, the weak  deflationary effects from the external sector on the Armenian economy  continue to persist.

 Economic activity in Armenia remained robust in the third quarter,  continuing to be largely driven by meaningful growth in construction  and trade. The latter continues to be impacted by certain short-term  factors, posing significant uncertainty with respect to the  sustainability of economic growth, its long-term outlook, as well as  the strength of domestic demand and consumption conditions. External  demand for services continues to slow relative to 2023. At the same  time, risks for demand pressures stemming from fiscal policy continue  to persist. Further, labor market conditions continue to cool, as  reflected in the cooling pace of wage growth, and stabilizing  non-traded sticky price inflation.  In order to manage possible risks  stemming from conditions of high uncertainty, the Board considers  multiple scenarios during its deliberations. On the one hand, the  Board discussed scenarios where possible underlying developments  would require a higher path for the policy rate relative to current  market expectations. This includes scenarios related to uncertainty  about the country risk premium and the neutral interest rate. On the  other hand, the Board discussed scenarios where potential economic  developments- including the risk of cooling labor market conditions  driving a weak demand environment-would cause inflation to  persistently remain at a low level. This would imply a more rapid and  aggressive downward path for the policy rate than what is currently  priced in markets in order to sustainably bring inflation back to  target in the medium-term horizon.

Seeking to minimize the losses that could stem from these and other  scenarios materializing, and balancing the aforementioned risks in  both directions, the CB Board finds it appropriate to continue to  gradually ease the policy stance. The Board resolutely affirms its  commitment to adopting the appropriate policy actions and strategy to  ensure the price stability objective of 4% inflation in the medium  term.

Summary of Economic Conditions

In Q3 2024, economic activity among Armenia's main trading partners  has been mixed; however, risks of weaker economic activity going  forward continue to persist. Uncertainty continues to surround  economic fundamentals in the US. On the one hand, despite an elevated  policy rate in recent quarters, the US continues to experience strong  growth, spurred by persistently robust consumption and domestic  demand conditions. While inflation has slowed, sticky prices and wage  growth still remain uncomfortably above their target levels,  demonstrating the challenges that monetary authorities face in the  "last mile." On the other hand, continued tightening of financial  conditions, and the gradual depletion of excess savings, poses risks  of a quick deceleration of consumption moving forward. Further, in  the context of the Fed's dual mandate, risks of weakening labor  market conditions imply a greater degree of readiness by the Fed to  begin the loosening cycle. Looking ahead, the key uncertainty relates  to the pace and magnitude of future policy easing, given financial  sector vulnerabilities and still-strong consumption and demand  conditions.  The latter additionally raises questions about a  potentially higher underlying neutral rate in the US. This would have  implications on both the future stance of Fed policy and capital  flows to emerging markets. In the Eurozone, the ECB cut interest  rates by 25 basis points in June, and kept the policy rate unchanged  in July. However, there are only few clear signs that the  inflationary environment has fully abated. On the other hand, while  growth in the services sector contributed to rebounding economic  activity in H1 2024, risks of economic slowdown still persist. The  structurally weakened position of industry and manufacturing in key  Eurozone economies remains a cause for concern. These risks, as well  as concerns related to the stability of the real estate market and  financial system in China, continue to remain key sources of  uncertainty driving a weaker global economic outlook. Meanwhile, the  Russian economy continued to experience high growth and strong  domestic demand conditions. Amid these conditions, the CBR increased  policy rates by 200 basis points in July, with the potential of  future rate increases. At the same time, the sustained imposition of  stricter and more targeted Western sanctions continues to pose risks  to the medium- term Russian economic outlook. The inflationary  environment in global commodity markets continues to remain weak,  though upside risks exist. Heightened geopolitical tensions in the  Middle East, which show few signs of easing, continue to threaten  both higher and more volatile energy prices as well as potential  disruptions to global supply chains. At the same time, food prices  continue to remain below the high levels of the previous two years.

Domestic Demand Conditions 

Economic growth in Armenia in Q2 2024 remained above estimates of  long-run sustainable growth (approximately 5%), comprising 6.4% Y-o-Y  growth. Growth was primarily driven by construction, trade, and  financial services. Additionally, previous quarters' economic growth  figures downward were revised downwards, owing to a reevaluation of  value added within the manufacturing sector. The persistence of  abovepotential growth, as well as the non-widespread nature of recent  growth, poses certain uncertainties regarding the relative position  of aggregate demand versus aggregate supply in the economy. The  robust external demand observed since 2022 has been gradually  weakening in 2024, as reflected in the stabilization of both real  expenses per tourist and tourist arrivals. In the wake of weakening  global demand for IT services in recent months, production and  exports in this sector have continued to decline, while some modest  outflows of foreign, relatively high-skilled IT workers have been  observed. Nevertheless, exports of other, "traditional" product  groups- e.g. brandy, cigarettes, mineral water, and so on-remain at  stable levels. Meanwhile, considerable uncertainty continues to  surround current domestic demand conditions. On the one hand, strong  growth in retail trade, consumer credit, domestic tourism, and other  services points to strong domestic demand. On the other hand, recent  economic growth has been fairly concentrated in certain sectors,  remittances have continued to decline, and labor market conditions  have eased somewhat. These factors, coupled with the overall weak  inflationary environment for several successive quarters, could point  to weaker demand conditions in the economy. Uncertainties also  surround the outlook and future trajectory of domestic demand  conditions. Key uncertainties relate to the reduced debt burden  (given higher incomes); the future utilization of accumulated savings  in the private sector; slowing wage growth; and geopolitical and  regional uncertainties. For example, depending on how and in which  direction savings are spent (consumption vs. investment), this could  have different implications on the relationship between aggregate  demand and aggregate supply in the economy. Additionally, risks for  modest demand pressures stemming from fiscal policy continue to  persist. This is driven by risks of revenue underperformance, as well  as high current expenditures given the imperative for various social  support programs.

Labor Market & Inflation 

The labor market has continued to cool in recent months. The  household survey-based unemployment rate in Q2 2024 increased to  15.5%. Considering uncertainty surrounding the level of unemployment,  it is important to continue to monitor potential development  scenarios and their consequences. On the one hand, the increase in  the unemployment rate could reflect arguments for weakening demand  conditions across the economy, given that the uptick in unemployment  has been driven by increases in the number of unemployed rather than  increases in labor supply. On the other hand, the total number of  registered employees, per State Revenue Committee data, continued to  increase. This could suggest that labor conditions are tighter than  what the household survey suggests. Alternatively, the growth in  registered employees could reflect gradual, structural declines in  the shadow labor market in favor of formal employment. Slowing wage  growth in recent months could support arguments of cooling labor  market conditions and weakening inflationary pressures from the labor  market. Wage growth continued to decline in July, standing at 4.1%  Y-o-Y. Moreover, wage growth has been somewhat concentrated in  certain sectors, while other sectors of the economy have seen slower  or flat wage growth. Looking ahead, on the one hand, there is  potential for labor force participation and supply to increase at a  more meaningful pace.  This could be supported by the possible  weakening seasonal emigration of Armenian workers as well as a more  rapid integration of forcibly displaced NagornoKarabakh Armenians  into the labor market. Such a scenario would moderate inflationary  pressures from the labor market in the medium to long term and  contribute positively to potential GDP. On the other hand, the number  of foreign citizens employed in Armenia has declined somewhat in  recent months. If this trend were to accelerate, this could have  negative impacts on both labor supply and potential GDP. The weak  inflationary environment has persisted in Q2 2024, primarily driven  by weakened pressures coming from the external sector and somewhat  weaker aggregate demand conditions. In this context, overall CPI  inflation has remained below target since April 2023, standing at  1.3% Y-o-Y in August 2024. Non-Traded Sticky Price Inflation, which  captures domestically driven demand dynamics, continued to stabilize,  standing at 2.4% Y-o-Y in July 2024. At the same time, weak  inflationary pressures in the services that are highly exposed to  external demand continue to reflect trends of slowing demand.  Nevertheless, high uncertainty still surrounds household inflation  expectations. In the context of the latent risks and uncertainties in  the current period.

Monetary Policy Market

Expectations of the CBA policy rate path have adjusted very slightly  downward since the latest decisions, and continue to reflect  expectations of a gradual reduction in the policy rate over the next  eight decisions.  Since the CBA's latest policy rate decisions, the  short part of the yield curve has slightly shifted downward, while  the long part of the curve remained stable. At the same time,  according to CBA estimates, it is likely that, besides market  expectations about the future policy rate, the yield curve also  reflects certain other risk factors. The country risk premium  continues to remain at relatively low levels since the beginning of  the year, with some upward revisions over the last weeks, while the  perceived riskiness of emerging countries overall continues to  decline. This could reflect both country-specific and regional  uncertainties, including tensions on the state border, regional  geopolitical developments, and other factors. In this context, an  upward reappraisal of the country risk premium could pose  inflationary risks. At the same time, macroeconomic stability in  Armenia and high economic growth can serve as important preconditions  for a potential reassessment of the country risk profile. Considering  the persistence of numerous types of uncertainty, the CBA builds and  evaluates several different scenarios for future economic  developments in order to manage possible risks stemming from these  key areas of uncertainty. The illustrative Case A scenario presented  in the MPR, where the policy rate path would need to be higher than  market expectations, is motivated by the assumption that the country  risk premium of Armenia sits somewhat lower than its fundamental  level. There thus would be risks of a quick adjustment to its long  run sustainable level because of continuous regional tensions and  uncertainties regarding geopolitical developments. In the event of a  quick adjustment of the country risk premium, there could also emerge  risks of increased volatility in financial markets and de-anchoring  of inflation expectations. In this context, the CBA policy rate path  would need to adopt a tighter stance relative to current market  expectations in order to reflect the elevated country risk premium  and neutral interest rate and guard against these adverse outcomes.  The illustrative Case B scenario presented in the MPR, where the  policy rate path would need to be lower than market expectations, is  motivated by the risk of a negative demand environment emerging in  the domestic economy. Specifically, the increase in the unemployment  rate and cooling private wage growth, as well as the weak  inflationary environment, poses risks of relatively weaker  longer-term demand conditions emerging. Over the medium term, these  factors could pose risks of more persistent deflationary forces  taking hold. In such a situation, the CBA policy rate would need to  follow a sharper and more aggressive downward path than what markets  presently expect, in order to stimulate demand and return inflation  to the target over the medium horizon.

In the context of the latent risks and uncertainties in the current  period, the CBA builds and discusses various scenarios, summarized in  the Taxonomy of Scenarios, with the aim of managing possible risks  and assessing sources of uncertainty. At the same time, the MPR  includes a deeper dive into two illustrative scenarios, which reflect  illustrative future paths of the economy that would require either a  higher path for the policy rate (Case A) or a lower path of the  policy rate (Case B) relative to current market expectations.  These  illustrative scenarios do not represent a most-likely future, assign  weight or probability to outcomes, or include all possible risks and  uncertainties.