CEE: inflation a growing risk as economies re-open

  • Price pressures in Central Europe are building from a broad range of sources and, while most of these are likely to be temporary, the issue is that countries were experiencing stubbornly high inflation before these pressures emerged. With output gaps set to close more quickly than in other parts of the emerging world by 2023, we think that the risks over the coming years are skewed to a prolonged period of much higher inflation and, subsequently, more aggressive monetary tightening.
  • The global reflation debate has heated up as economies have re-opened and price pressures are building. The clearest sign of this so far is in the early stages of the supply chain. The input and output prices components of the manufacturing PMI rose to new record highs in Czechia and Poland in May. (See Chart 1 and here.) Producer price inflation has surged to its highest rate since 2001 in Hungary. (See Chart 2.)
  • The cause of these pressures reflects significant global demand-supply imbalances. (See the Global PMIs for May, here.) Strains in global supply chains have intensified as demand for goods has been accompanied by shortages of raw materials and supply bottlenecks in key manufacturing countries, pushing up prices. Shortages of semiconductors have gained the most attention, but a growing number of firms across a range of sectors have reported that shortages of equipment and materials are limiting production. (See Chart 3.)
  • The key concern now for central banks is the extent to which these price pressures will be passed through to consumer prices. There is a lot of complexity around the supply chain price process. Producer prices are dominated by intermediate goods (those used in the production of final goods) and there is no static relationship with consumer prices – the strength of the pass-through depends on factors such as the number of links in the production process, the health of final demand and firms’ willingness to adjust their margins.
  • As a result, we only observe broad co-movement between producer prices and non-energy consumer goods prices. Chart 4 shows that the relationship in Poland is patchy. For Hungary and Czechia, the relationship is not worthy of a chart. Having said that, consumer prices are likely to be more sensitive to these pipeline price pressures if they continue to mount as firms’ profit margins in Central Europe were under pressure coming into the pandemic from strong wage growth and rising unit labour costs. (See here.)
  • Of course, price pressures won’t be confined to the goods sector as services hardest hit by the pandemic (air travel, leisure and food and accommodation services) are likely to experience some “re-opening” inflation. There is uncertainty about how far prices will rise, but our baseline assumption is that prices will normalise towards pre-pandemic levels rather than surge far above those levels.
  • While many of these factors are likely to persist through this year, the overall impact should be temporary and we expect inflation to ease in 2022. Once goods shortages ease and the impact of the re-opening fades, inflation will be largely determined by how quickly aggregate demand recovers relative to aggregate supply.
  • One way to analyse this is with output gaps, which show the balance between actual output and potential output (that consistent with target inflation). Potential output has been restrained during the pandemic due to lockdowns and restrictions but, even as supply capacity increases after economies re-open, we think this will be accompanied by a strong recovery in demand due to the vaccination rollout reducing precautionary behaviour, potential use of forced household savings, loose fiscal policy and significant EU fund inflows.
  • We expect output gaps in Central Europe to close in 2023 but the risk is that they close more quickly. That could generate a more sustained rise in inflation from 2023 onwards than we outlined in our Focus earlier this year. The concern is that with inflation coming into the pandemic at multi-year highs and little sign of disinflation during the crisis, inflation could remain stuck well above central banks’ targets.
  • All this suggests to us that when central banks do eventually start to hike interest rates (this year in Czechia and Hungary, 2023 in Poland), they will need to deliver significant monetary tightening to stem inflation. We are confident that the Czech central bank will deliver and expect 200bp of rate hikes by end-2023, which is more than investors expect. But we’re not yet convinced that there will be appetite for this amount of tightening in Poland and Hungary over the next two years. Our view is that there will be more aggressive tightening in Poland and Hungary from 2024 when inflation becomes stronger and more persistent.

Chart 1: Czechia and Poland Manufacturing PMI Input & Output Prices

Chart 2: Industrial Producer Prices (% y/y)

Chart 3: Manuf. Firms Citing Shortages of Materials and/or Equipment as a Factor Limiting Production

Chart 4: Poland Core Goods Consumer Prices & Non-Food Manufacturing Producer Prices (% y/y)

Sources: Refinitiv, Eurostat, CEIC, Capital Economics

Liam Peach, Emerging Europe Economist, liam.peach@capitaleconomics.com

Liam Peach Emerging Markets Economist
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