Inflation takes shine off booming central Europe

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Central Europe is at the forefront of a surge in inflationary pressures in Europe. Inflation in Poland hit 4.7 per cent in May before easing to 4.4 per cent in June. Hungary has the highest inflation in the EU at 5.1 per cent. Some of this is due to transitory factors. But there are also reasons to think price pressures are here to stay in these two countries, creating potential tensions between their central banks and their free-spending nationalist governments.

It also risks putting a dent in their carefully cultivated reputations for macroeconomic orthodoxy. Appreciation in Brussels and Berlin of their economic management — making them a favoured destination for German investment — has helped shield Budapest and Warsaw from closer scrutiny of their domestic agendas of reining in media freedom, curbing minority rights and politicising the judiciary.

Inflation in Poland and Hungary is well above the two central banks’ respective midpoint targets of 2.5 and 3 per cent over the medium term. Yet Adam Glapinski, Poland’s central bank governor, is in no hurry to raise rates. Glapinski told the FT there was “no cause for alarm” about inflation in his country. The uptick was largely caused by supply-side and regulatory factors, he said.

In Hungary, Gyorgy Matolcsy, the central bank governor, last month called on the government to drastically tighten fiscal policy — bringing the deficit down from an expected 7.5 per cent of gross domestic product this year to 3 per cent next year. The government’s fiscal plans were a “mistake”, he said.

Matolcsy was rebuffed by Prime Minister Viktor Orban who has dangled the prospect of a hefty income tax cut for families with children (an echo of Warsaw’s “Polish deal”) just in time for next year’s parliamentary election, which is shaping up to be a tight race.

Orban also appeared to fire a shot over the governor’s bows, saying he hoped any interest rate rises would be “cautious and measured”. The central bank later raised its main policy rate by 30 basis points to 0.9 per cent, the first hike in a decade. It also said it would carry on tightening on a monthly basis.

Capital Economics said in a recent note that central European economies were experiencing “stubbornly high inflation” before the latest pressures linked to the end of the pandemic and that “the risks over the coming years are skewed to a prolonged period of much higher inflation and, subsequently, more aggressive monetary tightening”.

The European Bank for Reconstruction and Development, the multilateral lender, has also flagged its concern. Beata Javorcik, chief economist, said there were short-term factors such as pent-up demand at the end of the pandemic, but that there were also longer-term ones.

The first is the region’s red-hot labour market, exacerbated by its poor demography. Average wages rose 10.6 per cent and 7.8 per cent in Hungary and Poland respectively last year, despite the economic slump. Unemployment in Poland is a mere 3.1 per cent. It may be able to draw on Ukrainian migrant labour, but Hungary’s anti-immigration government is less inclined to do so. Second, money from the EU recovery fund will start to flow later this summer through the next four years, further pumping up demand — as will income tax cuts from both governments.

Third, decarbonisation will push up producer prices in these economies still heavily reliant on fossil fuels. Lastly, unlike western Europeans, older Hungarians and Poles still have memories of hyperinflation at the end of communism, meaning their expectations of price rises could shift more quickly — a headache for central banks with only a short history of independence. “If those expectations jump up, the cost of bringing down inflation is going to be high,” Javorcik said.

The return of inflation in advanced economies may turn out to be more of a phantom than a menace, but in central Europe, thanks largely to demographics, it is a real threat. The region is bouncing back quickly from the pandemic, supported by the rebound in trade. And higher inflation and wage growth goes with economic convergence with richer neighbours. But for many people, rising prices are already eating into their living standards. Unless central banks act resolutely, there may be trouble ahead.

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