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Emerging Markets

Russia-Ukraine war set to worsen CEE’s inflation problem 

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The outbreak of war has added to inflationary pressures, forcing European central banks to hike rates even as growth is slowing

The Czech central bank set the tone for the economic debate at the EBRD’s annual meetings with an unexpectedly large hike in interest rates late last week. The rise of 0.75 percentage points to a 23-year high of 5.75% was more than analysts had expected.

The move was a response to the latest jump in inflation, which hit 12.7% in March and looks set to rise further in the coming months — the central bank expects inflation to top 14.5% this quarter.

This pattern can be seen across the EBRD’s area where the outbreak of war between Russia and Ukraine looks set to add to inflationary pressures that have already been building across the world.

The International Monetary Fund forecasts inflation in emerging European economies — but excluding Russia, Ukraine, Belarus and Turkey —will accelerate 9% this year, 3.4 percentage points up from its January projections.

The current episode of inflation started with a mismatch between supply and demand, as spending patterns shifted away from services and towards goods. This was exacerbated by the so-called “great resignation” as many workers chose not to return to the labour market when the pandemic hit leading to tight labour markets. And then the war in Ukraine sent commodity prices sky high.

Beata Javorcik, the EBRD’s chief economist, says taming inflation caused by this “triple whammy” will certainly not be easy. “My greatest fear is inflation spiralling out of control, resulting in social unrest and political instability,” she says.

A period when central banks viewed the rise in inflation as transitory has ended — last week the US Federal Reserve ordered a 0.5 percentage point hike in rates to 1% and its chairman, Jerome Powell, said additional half-point rises “should be on the table at the next couple of meetings”.

Javorcik says tight monetary policy in advanced countries will increase the cost of servicing foreign debt for emerging markets. “Moreover war, uncertainty [and] sanctions may lower risk appetite on the part of investors, leading to capital outflows from emerging markets,” she said last week in a discussion with her predecessor Professor Sergei Guriev.

The trend towards tighter monetary policy is visible across Europe. The Polish national bank matched its Czech counterpart with a 75bp rise to 5.75% but held back from a forecast 100bp rise saying “a gradual slowdown of economic growth is forecast”.

All eyes will be on the European Central Bank, which is finally signalling the need for higher interest rates after months of messages from its president, Christine Lagarde, playing down the prospect.

At its April meeting the bank said inflation had broadened across the economy with pressures intensifying “across many sectors”, and Lagarde conceded that inflation was “key of all our concerns”.

Capital Economics anticipates eight 25bp rate hikes between July and the end of 2023, bringing the deposit rate to 1.5%. Andrew Kenningham, its chief Europe economist, says while that would be slightly faster than investors anticipated, particularly during 2023, it is slower than the bank’s two previous significant tightening cycles. “If policymakers wanted to slam on the brakes, they would need to go even higher.”

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