Directional Economics EMEA: Core problems

Unlike Western economies where inflation should be inflecting lower by the end of 2022, many economies in Central and Eastern Europe (CEE) will be struggling with high core inflation. Across the region, the domestic policy mix, designed to protect household purchasing parity, leaves economies open to second-round price effects. Expect high core CEE inflation in 2022 to make the case for policy rates staying higher for longer.

When we published our last edition of Directional Economics in March – Some Like it Hot – the focus was very much on which of the central banks in the CEEMEA region were prepared to tolerate or look through high inflation. Since then, the surge in energy prices and the upward drift in inflation expectations have made such a stance untenable. With the exception of Turkey, policy rates are now being raised across the region. 

Driving headline inflation into the 7-10% YoY area (Turkey 21%) has clearly been energy prices for which the share in the CPI basket lies anywhere between 12% (Russia) and 25% (Poland). But while Western economies should see headline inflation lower through 2022 on energy base effects, the story in CEE will be the legacy of tight labour markets, decent growth rates and loose fiscal policy sending core inflation higher.

Many authorities in the region are introducing policies to protect household purchasing power, an ‘inflation shield’ as it is being called in Poland. While some measures, such as VAT tax cuts on energy, may temporarily lower headline inflation, common support measures, such as minimum wage hikes, will keep domestic demand strong. For reference, minimum wage hikes in the region are: Turkey (possibly 30%), Hungary (20%), Romania (11%), Russia (8.6%) and Poland (7.5%).

The political cycle clearly plays a role here as well given Hungarian elections next April and Polish and Turkish elections due in 2023 – all suggesting fiscal policy stays loose. In this environment we expect CEE central banks to push the monetary brakes ever harder and look for policy rates to move to the 3% area in Poland and Romania, to 4.2550% in Hungary and to 8%+ in Russia. Turkey will continue on its own path, as the Erdogan administration pursues domestic growth policies. 

Vaccine hesitancy and institutional mistrust mean that some countries remain vulnerable to Covid-19

Away from inflation and policy rates, the region will of course have to continue battling the virus. Vaccine hesitancy and institutional mistrust mean that some members of the region, particularly Romania, remain vulnerable to continuing waves of the virus. Equally, continued supply chain disruptions, especially in the auto sector, leave a country like Hungary more exposed than a diversified economy like Poland.

In addition, Poland and Hungary’s battles with Brussels over Rule of Law issues will extend into 2022 and could delay the disbursement of EU funds to mid-2022. Yet loose fiscal policy in those countries should soften the effects of any delays. Talking of Brussels and EU funds, Croatia remains one of the largest recipients of EU funds (nearly 12% of 2019 GDP) and the prospect of Eurozone entry in early 2023 will keep upgrade prospects in play.

Elsewhere in the region, Covid-19 and inflation have taken their toll on Russian household income and pose a challenge to Russia’s plans for fiscal consolidation. Here it looks like Russian GDP will revert closer to the 2% region seen over prior years even if the rouble does stay strong. And the world will continue to closely watch Turkey’s pursuit of growth and tolerance of a weaker currency through 2022.