Should we be concerned about the inflation?

Inflation has increased in most countries during the past year, but the picture is not uniform. Inflation has, for instance, dropped for the last couple of months in Turkey even though the Central Bank has cut the interest rate. Several countries have not yet reported January inflation but it was, for instance, surprising on the downside in the Czech Republic, where it dropped from 2.3% in December to 1.7%. Inflation also decelerated in Estonia, dropping from 5.7% in December to 5.3%, even though the Euro was introduced in January. Most concern has been directed to China but it is sometimes forgotten that inflation actually fell from 5.1% in November to 4.6% in December. It is too soon to determine if that is a trend shift (see previous post) but we will have a better idea when the January numbers are released.

The first reason not to be too concerned about the recent inflationary push in Eastern Europe is that levels are still relatively low. It is illustrative to compare this year with 2008 since growth was about the same and commodity prices were similarly high. Even though the inflationary forecasts may be revised up somewhat for this year (the most recent IMF forecast suggest that average CPI will be half compared to three years ago) inflation will be so much lower that we can talk about a new inflation regime in Eastern Europe.  

The second reason is that much of the current inflationary pressure comes from food and energy. Food makes up one third of the Russian CPI basket and more than half of the Ukrainian one. In Turkey and Poland, the share is roughly one fourth. The drought and wild fires in Russia obviously had a big impact on inflation there and the overall poor harvest last year had an impact on food prices globally. If harvests are good or normal this year, food inflation and thus overall inflation should moderate in the second half of the year.

The third and perhaps most important reason is related to the persisting output gaps in Eastern Europe. Whereas emerging markets in general and Asia in particular has grown in cumulative terms since before the crisis, most countries in Eastern Europe are still below their pre-crisis levels of economic development in real terms. This suggests that there is plenty of spare capacity – unemployment and underutilization of physical infrastructure – that should keep a lid on inflationary pressure. 

This is not to suggest that we should not be concerned about inflation at all. It will certainly continue to rise in most countries in the near future and should lead to interest rate hikes. The point is that I think it will stay in relatively low levels for Eastern Europe compared to what we have been used to.