Most recent Economic Perspectives for Central and Eastern Europe
Explaining skyrocketing inflation in Central and Eastern Europe
The period since the outbreak of the Covid-19 pandemic has been one of the most turbulent periods experienced by European economies since the end of World War II. Most notably, there were numerous lockdowns, collapsing global supply chains and generous government subsidies to companies and households. Over time, the recovery of growth after the pandemic subsided and the Russian invasion of Ukraine began. These events, among other negative manifestations, have fed into a phenomenon that many countries, not only on our continent, are still struggling with today: high consumer inflation.
Having only relatively recently climbed to long-term highs, price growth in the CEE region is finally starting to falter. It can be expected that, just as the time profile of price increases has varied in different countries, the opposite movement, i.e. a decline towards a new inflationary “normal”, will also show a different trend, whatever this may look like. Which factors may accelerate or, on the contrary, slow down the desired development in the CEE region?
The inflationary upswing after January 2020 was stronger in Eastern Europe than in the “old” EU countries. The more than 20% price level increases in March 2023 are almost exclusively encountered in the CEE region (see figure CEE1).
Which main categories of goods and services contributed most to price growth in CEE during the period under review? Table CEE1 summarises the average contributions (in percentage points) of items falling into COICOP categories 1-12 to annual inflation in the four CEE countries (Czech Republic, Hungary, Poland and Slovakia) and in Belgium (representing the “old” EU).
Table CEE1 - Average monthly contributions to annual inflation by COICOP category between January 2020 and March 2023 in percentage points
Source: KBC Economic based on OECD
Categories: Food & Non-Alcoholic Beverages (COICOP 01), Alcoholic Beverages, Tobacco & Narcotics (COICOP 02), Clothing & Footwear (COICOP 03), Housing, Water, Electricity, Gas & Other Fuels (COICOP 04), Furnishings, Household Equipment & Routine Household Maintenance (COICOP 05), Health (COICOP 06), Transport (COICOP 07), Communication (COICOP 08), Recreation & Culture (COICOP 09), Education (COICOP 10), Restaurants & Hotels (COICOP 11), Miscellaneous Goods & Services (COICOP 12)
The table shows that there is no simple pattern behind the noticeably stronger rise in inflation in CEE, which is common across the region and at the same time significantly different from the pattern of price growth in Western Europe. While in the Czech Republic housing has pushed up prices the most (COICOP 4), followed by food and non-alcoholic beverages (COICOP 1), in Hungary it is food that tops the inflation ranking by a wide margin, followed by transport (COICOP 7). In Poland, as in the Czech Republic, housing prices dominated inflation, but unlike in the Czech Republic, their lead over food was marginal. In Slovakia, food was the main contributor to inflation in the period under review, as in Hungary, but only marginally ahead of the effect of housing prices.
In the CEE region, the relative order of contributions to price inflation in the Czech Republic was probably closest to Belgium (where housing prices clearly came first, followed by transport prices, with food prices almost identical). Services and goods from almost all COICOP categories, however, contributed to the fact that the price level in the Czech Republic was one third higher in March 2023 than in January 2020, while in Belgium the increase was only 16%. The largest differences in the magnitude of the average inflation contribution in the two countries can be seen in categories 4 (housing), 1 (food and non-alcoholic beverages) and 2 (alcoholic beverages and tobacco). The finding that we can see higher price increases across the consumer basket compared to Belgium is observed also in other countries in the CEE region. The explanation is that the relatively stronger inflationary impulse from the energy sector at the beginning gradually seeps through the economy, where it may be amplified (for example, by the overhang of deferred demand) or weakened (for example, by government price caps) in individual markets.
Among the main reasons why rising consumer inflation has hit the CEE region harder than Western European countries and why price developments differ significantly (both in magnitude and structure) even across the CEE region are higher fossil energy intensity and different economic structures (production and ownership). In addition to the different responses of governments to the price surge, the behavior of central banks, i.e. the timing and vigor of monetary tightening, has also played an important role. As regards the energy component of price growth, which has long dominated inflationary pressures, the historically massive dependence on supplies of relatively cheap natural gas and oil from the East, whose shortfall could not (and still cannot) be smoothly replaced by supplies from elsewhere, played a very negative role in the CEE region.
In recent months, we have observed that the role of energy as the main driver of price growth in CEE has been weakening, while food has been more noticeably hampering a faster decline in inflation. Going forward, however, we can expect that also inflationary pressure of traditionally price-volatile food will fade relatively soon, and the role of the main inflationary impulses could then be taken over by so far less visible factors: unanchored inflation expectations, rapid wage growth and widening fiscal deficits. All three of the latter variables are closely interlinked.
Unanchored inflation expectations of households and firms stimulate wage growth pressures in both the private and public sectors. Wage growth in the public sector leads to an increase in budgetary expenditures (not only because of higher public wage payments but also for pensions and social benefits´ indexation). The risk of too rapid wage growth in CEE is exacerbated by the relatively low unemployment rate, which in March 2023 stood at 2.6% in the Czech Republic, 2.8% in Poland and 3.9% in Hungary. Even in Slovakia, where the unemployment rate reached 6.0%, it was only slightly higher than in Belgium (5.9%) and remained below the level of the euro area (6.5%). Regarding future potential inflationary pressures stemming from deficit budgets, another specific risk can be identified in the CEE region, this time in the form of a relatively low level of indebtedness (which may make governments more fiscally benevolent). As a share of GDP, public debt in the last quarter of last year was 44% in the Czech Republic, 49% in Poland, 59% in Slovakia and 73% in Hungary. In the same period, the ratio was 92% in the euro area and 105% in Belgium.
The last paragraph suggests that the answer to the question of how quickly and effectively the price drop will be slowed down in the CEE region in the future will, in addition to external influences, depend primarily on the foresight and courage of the respective governments and central banks to take politically unpopular measures that will appropriately complement rather than undermine each other.