Interest rates

Policy interest rates rise in Romania and CEE as central banks continue monetary tightening due to soaring inflation

Inflation has soared, but the first signs of moderation have started to appear and inflation expectations, although high, remain anchored. In addition, the recession is knocking on the door and reducing demand pressures. On the other hand, the labor market has never been so tight, supporting dynamic wage growth. Central banks in the region have responded quickly with substantial increases in interest rates and only recently paused, according to a recent special research report by Erste Group titled “The spiral of wages and prices is- a real threat to the CEECs?”

Soaring commodity prices not only have a direct effect on inflation, reflected in the double-digit figures, but also on indirect inflation. Second-round effects are likely to remain a concern for central banks over the next year, as the pass-through effects of the recent shock on the wage and price-setting mechanism are only expected to occur with a lag. Moreover, they can potentially lead to a wage-price spiral. However, to enter the spiral, several prerequisites must be met in the economies.

Inflation undoubtedly soared in all Central and Eastern European countries, reaching as high as 20% in Hungary in September. More importantly, inflation numbers continue to surprise on the upside and double-digit readings are expected through 1H2023. Although external factors are expected to be disinflationary over the next year (lower oil and food prices and reduced supply chain disruptions), underlying demand pressures remain strong , underpinned by underlying inflation which is also entering into a double-digit growth dynamic. For second-round effects to last, the degree of competition also matters, influencing the pricing power of firms and their ability to raise prices.

In response to soaring inflationcentral banks continued monetary tightening. Policy rates increased by 5 percentage points in Romania, nearly 7 percentage points in the Czech Republic and Poland and more than 17 percentage points in Hungary. The labor market has never been tighter in the region, with unemployment rates at or near historically low levels in most CEECs. Low unemployment is also associated with a high vacancy rate. Structural aspects, such as the reduction in the population of working age or the low retirement age, strengthen the position of workers in the bargaining process. In addition, automatic wage indexation clauses also make wage-price spirals more likely. Finally, an accommodating fiscal policy is another important factor, weakening the efforts of the monetary authorities to curb inflation.

Prerequisites for the wage spiral

In general, the transmission effects of oil shocks on wage and consumer price inflation have been found to be higher in emerging European economies than in advanced economies (Baba, Lee, 2022). However, before the wage spiral occurs, certain preconditions must be met, as indicated by Boissay et al. 2022:

  • Rampant inflation
  • Unanchor inflation expectations
  • Not strong enough response from central banks
  • Low credibility of monetary authorities
  • Tight labor market conditions
  • Dynamic nominal wage growth
  • Fiscal easing

Inflation and inflation expectations are high

Inflation has undoubtedly skyrocketed, reaching as high as 20% in Hungary in September. Although the origins of the recent shock are mainly external (soaring energy and food prices), they cannot be entirely attributed to recent price increases. Underlying demand pressure had increased before the outbreak of war in Ukraine, as evidenced by the increase in underlying inflation.

Worrying at this point is the fact that inflation numbers continue to surprise on the upside and double-digit readings are expected through 2023. Rising energy costs are still ahead of many Central and Eastern European countries and the development in Hungary is an example where inflation could accelerate once electricity prices rise. Fortunately, household inflation expectations have eased recently, as evidenced by the results of consumer surveys (the balance of responses to the question “How do you expect consumer prices to develop over the 12 coming months?”). According to the IMF, the less anchored inflation expectations are, the stronger the monetary response must be to avoid the “unanchoring” of expectations.

Beyond the adjustment of energy prices, over the next year, external factors should be of a disinflationary nature (easing oil and food prices and less disruption in the supply chain). supply). By contrast, core inflation was high. From the perspective of a wage-price spiral, pass-through effects tend to be stronger when the prevailing level of inflation is higher, and there is little doubt that this has been the case for some time. already. This is when monetary policy comes into play.

The monetary policy response matters

Higher monetary policy credibility is associated with lower pass-through effects (Baba, Lee, IMF Working Paper 2022). In response to the surge in inflation, central banks in the region proceeded with monetary tightening relatively quickly. Policy interest rates have risen by 5 percentage points in Romania, almost 7 percentage points in Czechia and Poland and more than 17 percentage points in Hungary since the start of the tightening cycle in mid-2021 . Monetary tightening in general is effective in lowering both inflation and inflation expectations, as recent IMF calculations suggest. Moreover, more anchored inflation expectations react less to shocks.

On the credibility side, some central banks in the region have announced the end of interest rate hikes (Czechia, Hungary) or a pause in the tightening cycle (Poland). Monetary conditions may be affected by other tools such as central bank balance sheet reduction via foreign exchange interventions in the case of the Czech Republic or tighter liquidity management and higher reserve requirements in the case of Hungary. Despite this, the Hungarian central bank was forced by the market to intervene and raised the effective interest rate to 18% in mid-October. It seems that the commitment to bring down inflation is the key factor in supporting the credibility of the monetary authorities.

Labor market conditions

Another determining factor in the persistence of inflation is the labor market. Tense conditions (low unemployment, high vacancy rate) favor the persistence of inflationary pressures, because the bargaining power of workers is generally higher when the demand for labor is strong and the supply of labor is high. -work is limited (Boissay et al. 2022, BRI Bulletin). Structural aspects of the labor market in the CEECs, such as the shrinking working-age population or the low retirement age, tighten the supply of labor in the region, strengthening the position of workers in the negotiation process.

Overall, the labor market has never been tighter. Despite the pandemic, unemployment rates are at or near historically low levels and vacancy rates have been increasing lately in many Central and Eastern European countries. Employment increased, but at a slower pace. Despite the deteriorating outlook, we have seen few signs of deterioration in the labor market so far. Expectations of an increase in the unemployment rate (as evidenced by the balance of responses to the survey question on whether you expect the unemployment rate to increase over the next 12 months) are in increase since the beginning of the year. Fear of employment can be a factor in weakening the position of workers in the bargaining process and slowing wage inflation.

Wage growth

One of the triggers for regime change could be nominal wage increases beyond price increases and productivity gains. Nominal wage growth increased more visibly in 2022 in Hungary, Poland and Romania and, between January and August, growth was double digit in all three countries. While in Poland and Romania the average inflation rate over this period remained slightly higher, in Hungary nominal wage growth exceeded the inflation rate. In Slovakia, wage growth has already accelerated in 2021 and this year has maintained momentum close to 8% year-on-year (January-August average), while in Czechia wage growth has been slow against its peers, averaging almost 6% in the first half of this year. In the Czech Republic, real wage growth has been the most negative so far.

Moreover, according to the ECB, automatic wage indexation clauses make wage-price spirals more likely. However, in the region, full indexation of public wage prices is not automatic unlike in the case of public pensions where indexation is provided for by law (except for Romania). In Poland, the minimum wage will be indexed twice in 2023, because, in the event of inflation above 5%, such an evolution is guaranteed by the legislation. In other countries, like Croatia, it is decided once a year by the government.

Tax policy

As central banks try to put out the fire of inflation, governments are stepping in to offset soaring energy costs. While this support protects the most vulnerable (low-income households that bear a high share of housing costs), governments should design their support and target it very carefully to avoid any large-scale stimulus that could be pro-inflationary at first. end.