The unanchoring of CEE inflation expectations

For some time, there has been focus on the eurozone inching closer and closer to outright deflation and the need for bold policy action from the ECB to ensure that this does not happen. However, there has been less focus on that the same thing is happening in a number of Central and Eastern Europe countries. Hence, Hungary already has deflation and the Czech Republic and Poland are inching much closer to outright deflation in coming months.

Historically, at least since the end of communism, deflation has not been a problem in Central and Eastern Europe and even though inflation in the region has gradually been brought down over the past two decades, inflation has normally been higher in CEE than in ‘core Europe’. Therefore, the local central bankers have also been concerned mostly about avoiding spikes in inflation and therefore they are likely to find it somewhat challenging to think about deflationary risks. However, in our view, there is a real risk that most CEE countries will come very close to having deflation in coming quarters and we believe that monetary policy easing is badly needed to avoid this.

If bold action is not taken, we believe it is very likely that inflation expectations will become unanchored. This would mean CEE central banks’ inflation targets losing their credibility. The loss of a nominal anchor for the CEE economies would be likely to lead to more volatility in both the CEE markets and the CEE economies. Therefore, in our view, it is paramount that the CEE central banks take action to ensure nominal stability and ensure market expectations for inflation are in line with official inflation targets.

There are numerous costs associated with deflation. Maybe the most important risk is that as the CEE economies slip further into deflation debt ratios (both public and private) will continue to increase as nominal income growth slows and maybe become negative. This is effectively a debt-deflation spiral and if this is allowed to get out of hand, the result could be renewed banking distress in the region and potentially a sovereign debt crisis. The CEE central banks have a responsibility to avoid this happening.

We have updated our inflation forecasts for the countries in the region and it is very clear to us that Poland, Hungary and the Czech Republic will all undershoot their central banks’ official inflation targets, not only this year but also in 2015 and 2016 (see the table on the right). Therefore, it is our view that the central banks in all three countries need to undertake policy action to ensure an increase in inflation expectations, so they ‘match’ the central banks’ official inflation targets. However, for now, it does not look as though the central banks of the region take these problems seriously enough and there is a major risk that deflation will soon become engrained in the economic system.

Paradoxically, from a purchasing power parity (PPP) perspective, the outlook for very low inflation or even deflation is actually positive for the CEE currencies. This is already reflected in our medium-term FX forecast for the CEE currencies. This said, the easiest way to avoid falling into a deflationary trap is for these countries’ central banks to engineer a weakening of their currencies. Once (if) this happens, we would recommend selling these countries’ currencies. However, the question remains when this will happen.

The US and EU introduce new sanctions against Russia

Overnight, both the EU and the US announced new sanctions against Russia in relation to the Ukrainian-Russian conflict. The US government has now added more Russian companies to the list of sanctions, among them major energy companies such as Rosneft and several Russian banks.

The expanded sanctions are, in our view, likely to have a further damaging effect on the Russian economy, which is already suffering from the effects of the conflict – directly and indirectly.

We believe that the Russian economy is effectively already in recession and the continued downturn in the economy is likely to put renewed pressure on Russian markets. Overnight, the rouble fell in offshore markets the most in two weeks.