Albania Watch: From hike to strike, BoA surprises with a rate cut

Bank of Albania not only hit the brakes on rising interest rates in the July meeting but surprisingly, announced a 25bps reduction in the base rate to 3.00%. This marks a pivot from the tightening cycle implemented over two years in response to inflationary pressures stemming, among others, from the war in Ukraine. The decision came on the heels of a surprising decline in inflation in Albania during the first half of 2024. Inflation fell faster than anticipated, reaching an average of 2.1% in April and May. This represents the lowest level since July 2021. Core inflation has also mirrored this trend. It dropped to 2.4% yoy in April and 2.3% in May, marking its lowest point since late 2021.

Several factors contributed to the unexpected dip in inflation, with external influences playing a significant role. Decreasing prices in global markets, combined with the appreciation of the Albanian Lek, have made imports more affordable and this in turn has helped to dampen inflationary pressures domestically. Additionally, yoy comparisons are becoming increasingly favourable as they move beyond the period of high inflation experienced in late 2022. In addition, it seems there has been a positive agriculture season for unprocessed food, which has an important place in consumers' basket. In notably changed language, BoA also announced that they expect inflation to hold steady for the rest of 2024 before gradually rising back towards the 3% target level in H1 2025. Previously, the central bank was expecting inflation to converge to the 3% target in the second half of 2024.

Key Rate (eop)

Source: BoA, RBI/Raiffeisen Research

However, in our view, the decline in inflation largely reflects reduced imported inflation due to similar trends in trading partners and a strengthening currency. The reduction in food inflation aligns with regional trends, indicating a positive supply shock.

In our view, the focus should be on the domestic market; inflationary pressures there remain relatively stable, influenced by strong demand for goods and services, rapid wage growth, and rising production costs. Economic growth in the first half of 2024 seems to have been robust, supported by increased consumption, private investments, and tourism expansion. However, exports of goods have declined, and the public sector maintains a fiscal consolidation policy, resulting in a budget surplus.

The Albanian economy is in a positive business cycle phase, with businesses reporting increased utilization of productive capacities and positive labour market developments. Private sector wages grew by 12.7% in the first quarter, supporting disposable income and purchasing power. According to BoA, wage and production cost increases have only partially been passed on to consumer prices, reflecting productivity growth and reduced business profit margins.

However, the growth rate of bank credit in Albania continued to accelerate during April and May, averaging about 14%, with loans in Lek showing an impressive annual growth of 22% by May. This trend reflects low loan interest rates in Lek and increasing demand. The resulting higher share of loans in Lek has enhanced monetary policy effectiveness, although a significant portion of loans continue to be in euros. In addition, credit for the private sector is increasingly directed towards business investments.

The Supervisory Council of the Bank of Albania has reduced key interest rates by 0.25 percentage points, aligning also with the European Central Bank’s recent actions. The central bank tries to mitigate short-term inflation risks from supply shocks while maintaining medium-term price stability objectives. Future monetary policy decisions will be guided by ongoing assessments of domestic inflationary pressures and economic conditions.

Taking these developments into account, we have reassessed our projections for BoA’s monetary policy. We now project that the central bank will likely hold the base rate steady at 3.00% for the rest of 2024. We believe this wait-and-see approach allows the bank to monitor the ongoing effects of the recent rate cut and assess whether additional adjustments are needed to maintain a balanced and stable economic environment. However, in our opinion, the focus in the forthcoming year will be on unit labour costs to determine if any deterioration might compel businesses to raise prices and force the central bank to change course and move again towards the neutral rate level.