It is commonly accepted that relative prices in Russia were highly distorted under central planning and that liberalization prompted major shifts in the price structure. However, no systematic empirical analysis of the realignment of relative prices has yet been undertaken that would show to what extent and how fast prices have converged to some market economy benchmark since the onset of the transition. This question is explored in this paper for consumer prices, using several large data sets ranging from 1980 to 1994.
An empirical investigation confirms that after liberalization the structure of relative prices in Russia changed significantly. For goods, most of the permanent domestic realignment seems to have taken place by the end of 1992, even though some further shifts occurred in 1993 and 1994. For services, convergence to market levels is a more protracted process; by mid-1994, notwithstanding sharp increases in relative domestic terms, the prices of many important services remained far below advanced market economy levels. The gap between the domestic overall price level and the level prevailing abroad was huge in January 1992, narrowed substantially thereafter, but still loomed large in 1994. At the same time, the degree of integration of the domestic goods market, particularly for nonfood items, seems to have increased since early 1992. In addition, price-setting has become more synchronized as agents adapt to a high-inflation environment.
The large gap between domestic and international price levels that remains two to three years after price liberalization implies that convergence, inasmuch as it does proceed, will be accompanied by real exchange rate appreciation. The latter may take the form of a strengthening of the nominal exchange rate. However, the relative price of services can be expected to rise significantly in the years ahead, as cost-recovery ratios are still low for many of them. Thus, even if tight financial policies and foreign competition contain price increases in the tradable goods sector, the process of real exchange rate appreciation is likely to involve persistently higher measured inflation than in Western Europe.