The headquarters of the Czech central bank, also known as Ceska Narodni Banka (CNB), sit on the city skyline in Prague, Czech Republic, on Thursday, Aug. 4. 2016. The Czech central bank, in a meeting led by its first new governor in six years, kept interest rates at what it calls “technical zero” and maintained a commitment to cap appreciation in the koruna. Photographer: Martin Divsek/Bloomberg
The headquarters of the Czech central bank, Prague © Bloomberg

The European Central Bank may still be splurging €80bn a month on bonds as part of its monetary stimulus programme, but immediately to the east of the currency bloc, talk is already starting to turn to monetary tightening.

Forward markets are pricing in the likelihood of interest rate rises in Romania, Poland and Hungary within the next 12 months. And although few expect the Czech Republic to follow suit, the impending scrapping of its currency ceiling would be tantamount to a rate rise in the eyes of some.

“[The eastern European quartet] have had a really good past few years,” said William Jackson, senior emerging markets economist at Capital Economics. “They have been helped by a positive terms of trade shock via low oil prices, which kept inflation low and helped consumer spending, and they used spare capacity that was left over after the global financial crisis.

“But that looks like it’s starting to turn. There is less slack in the labour market and we have seen quite a sharp pick-up in inflation. It is starting to normalise,” said Mr Jackson, who sees Romania leading the way with its first rate rise in the second quarter of this year.

Arko Sen, emerging market strategist at Bank of America Merrill Lynch, said average inflation across Hungary, the Czech Republic and Poland (he does not cover Romania) had risen from -1 per cent in 2014 to +1.5 per cent, “with ample room to rise” further.

“Reflation looks here to stay and will likely drive [eastern Europe] over the next several years just as much as disinflation has driven markets since 2010,” Mr Sen said.

As elsewhere in the world, inflation in eastern Europe is being elevated by the recovery in oil prices, with the base effect of extremely low energy prices in late 2015 and early 2016 dropping out of annual inflation calculations. However, tightening labour markets may be more important.

“The market is getting somewhat distracted by oil price moves and base effect CPI [consumer price index] inflation narratives when the real and more substantive risk to CEE [central and eastern European] inflation is labour markets,” said Peter Attard Montalto, emerging market economist at Nomura.

He argues that weak oil prices and, in some countries, tax cuts, delayed a pick-up in inflation, but “now we think it is upon us and CPI inflation has already started rising higher in the last two months”.

In the Czech Republic, headline annual CPI inflation hit 2 per cent in December, up from 0.8 per cent in October, while Hungary saw a rise from 1 per cent to 1.8 per cent over the same period. Poland was still reporting deflation in October, with headline prices falling 0.2 per cent in the previous 12 months. By December this had turned into inflation of 0.8 per cent.

Much of this uptick will be driven by the base effect from rising oil prices but core CPI inflation, which ignores energy and food prices, is also starting to rise, albeit more modestly.

The Czech Republic reported core inflation of 1.3 per cent in December, up from 0.4 per cent in October, while Hungary saw a rise from 1.4 per cent to 1.7 per cent over the same period. In Poland, core CPI deflation eased from -0.4 per cent to -0.1 per cent. BofA sees these levels rising significantly this year, as the first chart, based on its forecasts, suggests.

Much of this appears to be driven by wage pressures. “The CEE labour market is strong and much tighter than the eurozone, laying the ground for more sustainable inflation processes,” said Mr Sen.

“The problem of labour shortages has been rising across all three countries, and is most severe in Hungary,” where a net balance of 70 per cent of companies say the availability of labour is a constraint on their business.

Almost a third of businesses in the Czech Republic and Poland report a similar problem, comfortably ahead of the level of perceived labour shortages in Germany, the eurozone’s strongest performing economy, as the second chart shows.

The unemployment rate in Hungary has plunged from a high of almost 12 per cent in 2013 to just 4.4 per cent, while the Czech Republic has seen a decline from 8.7 per cent in early 2014 to 5.2 per cent and Poland from 14.3 per cent in 2013 to 8.3 per cent, as foreign companies, such as carmakers, have poured into the region seeking cheap labour and a steady flow of EU cash has helped buoy activity.

Mr Sen’s analysis suggests that similarly low unemployment levels have historically correlated with wage growth of 8 per cent in the Czech Republic and double-digit growth in Hungary and Poland.

In Hungary, “the critical labour shortage” has already led to a 15-25 per cent increase in the minimum wage, he said, benefiting about a quarter of the workforce.

Taking into the account two ameliorating factors — that wage growth has already been outpacing productivity growth in the region, and that the aftermath of the global financial crisis appears to have brought about structural changes in wage-setting behaviour — he anticipates private sector wage growth of 8 per cent in Hungary this year and 5 per cent in the Czech Republic and Poland.

Mr Attard Montalto is less convinced about this, arguing that the strength of the Phillips curve, which measures the relationship between unemployment and inflation, is unclear in eastern Europe, amid “much uncertainty about why pass-through hasn’t taken place already after the marked falls in unemployment and rises in income growth”.

Nevertheless, the Nomura man does see core inflation rising to 3.5 per cent next year in Hungary, and 1.8-2 per cent in the rest of the region.

As the third chart, based on BofA’s forecasts, shows, real monetary policy rates are likely to turn sharply negative if central banks do not react to rising inflation, even if the trend is more muted in Poland. However, there is no consensus as to who will jump first.

Even though Romania is still experiencing deflation at both the core and headline CPI levels, Capital Economics expects its central bank to be the first to react.

Given expansionary fiscal policy, it expects inflation to hit 3.5 per cent in 2018. As such, Capital forecasts 100 basis points of tightening this year, taking the policy rate to 2.75 per cent, with the first rise coming in the second quarter.

Mr Attard Montalto, who warns of “overheating”, also eyes 100bp of tightening, although starting from the second half of 2017.

He foresees a similar level of tightening in Poland, albeit at a slower pace, with a first rate rise in November likely to kick-start 100bp of tightening over the next 18 months., given the likelihood of the central bank adopting a relatively “credible and orthodox” approach to rising prices.

Market expectations are consistent with this, with traders pricing in the likelihood of one 25bp increase in the next 12 months, according to data collated by Société Générale.

Of the three countries he covers, Mr Sen also expects Poland to go first. However, he does not see anything this year, but is instead pencilling in 50bp of tightening in 2018.

A more dovish still Mr Jackson believes Polish rates will be on hold for the next two years, with inflation only likely to reach 2.3 per cent in 2018, below the central bank’s 2.5 per cent target.

Market expectations are most hawkish in Hungary. The forwards curve is pricing in 20bp of tightening over the next six months, a rise of 9bp in the past week, according to SocGen, and 39bp of tightening over the coming year.

Those the FT spoke to are unconvinced, however. Mr Jackson sees Hungarian rates remaining on hold at 0.9 per cent throughout 2017 and 2018, given expectations that inflation will remain below the central bank’s 3 per cent target during this period.

Given a belief that the central bank wants a cheaper forint, Mr Attard Montalto believes it will refrain from tightening unless and until inflation reaches 4 per cent, the upper end of bank’s target range.

Mr Sen is somewhat more hawkish, however, forecasting 50bp of tightening in 2018.

The Czech Republic is something of an outlier. Not only has it cut rates to 0.05 per cent, but it has also successfully implemented a Swiss-style currency ceiling, holding the koruna at 27 to the euro.

There are widespread expectations that rising inflation will prompt the central bank to abandon this policy around the middle of this year, something Mr Sen said he would regard as tantamount to a first rate rise.

Few see much action beyond that, however, although, after a “prolonged pause”, Mr Sen does envisage 70bp of tightening in 2018.

But even that rate of change is likely to seem dramatic compared with eastern Europe’s neighbours in the eurozone, where QE reigns supreme. Even after a pick-up in eurozone inflation to 1.9 per cent this year, BofA sees it falling back to 1.4 per cent in 2018, removing any likelihood of even modest tightening then.

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