Food for thought as inflation in emerging Europe returns

By bne IntelliNews November 21, 2007

Nicholas Watson in Prague -

Recent data show that inflation, driven primarily by rising food prices, is back with a vengeance in Central and Eastern Europe. Economists are now predicting that the measures the authorities will need to take to head off this inflation could cut as much as 1.5 percentage point annually off GDP growth.

The global economy has proven remarkably resilient to the rise in commodity prices for a surprisingly long period, but with a regional drought causing a fall in the supply of food produce, this resilience appears to be wearing thin.

"This is drought-driven - most countries are affected and we have seen these countries buying up wheat ahead of next year," says Simon Quijano-Evans, senior analyst at Bank Austria Creditanstalt. "More price pressure could come in January, with the winter in the northern hemisphere leading to a potential surge in global demand."

While most people's attention was fixed on the fallout from the sub-prime mortgage mess in the US, the leap in Russia's consumer price index (CPI) - which measures the cost of basic goods - from 0.1% month-on-month in August to 0.8% in September took everyone by surprise. This means that 12-month CPI jumped to 9.4% in September from 8.6% in August, representing the largest monthly increase since January 2005. Then in October, monthly inflation totalled 1.6%, bringing annual CPI growth to 10.9%, well above the government's 9.0% target for 2007. In light of this, officials believe a more realistic prediction for annual rate is now 10.5-11%, "and some are now even wondering whether this new, higher target will be breached," says Erik DePoy, strategist at Alfa Bank.

This inflation, fuelled by food prices, is becoming increasingly evident in the EU's newest members. The result, says The Economist in its issue dated November 15, is that "Emerging Europe is flashing red."

Going Hungary

The countries most at danger are, of course, those like Russia and the CIS countries where food makes up a significantly higher proportion of the CPI basket. "A simple CPI basket food weight comparison underlines that Romanian, Turkish and Polish CPIs are most at risk," says Piotr Chwiejczak, an economist at UniCredit Group.

On November 14, Poland's Central Statistical Office revealed that food prices pushed Poland's annual inflation rate to 3.0% in October, above expectations, up from the 2.3% recorded in September and far above the central bank's 2.5% inflation target. Food and non-alcoholic beverage prices registered another seasonal rise in October, increasing 1.7% on the month, after a 2.4% jump in September. On the year, food prices accelerated 6.6% in October, compared with 5.1% in September.

In Romania, September's inflation jumped to 6% on year on the back of higher food prices. The CPI is now expected to peak at around 6.7% growth in October before slightly decelerating to around 6.0% through the end of the year, though remaining far above the upper range of the central bank's inflation target band of 4% plus/minus 1%.

Analysts were scrambling to revise up their inflation forecasts for Turkey after Turkstat revealed that the CPI increased by 1.81% in October, significantly higher than market expectations of 1.18%, as food prices rose 3.41% on month, the highest monthly increase since 2004. "In October, we can say that the Ramadan effect together with the negative effects of drought on unprocessed food prices exerted pressure on food prices," Oyak Securities said in a note following the release. "We revise our year-end CPI forecast to 8% from 7% - clearly the year-end target band of 4-6% will not be achieved."

Elsewhere, Hungary's October CPI rose 6.7% on year, accelerating from 6.4% in September and higher than the market consensus of 6.5%. Much of the rise was down to food prices, which rose 2% on month, though analysts warn that fuel price increases will show up in the November inflation data and there is speculation that administered price hikes (utilities, public transport, household energy etc.) will be in the double-digits at the beginning of 2008.

"In the short run, [we] expect more pressure coming from food prices - especially meat prices are seen to further increase," say analysts at Raiffeisen. "We expect inflation to further increase in the rest of the year (above 7%), and forecast above 6% inflation in the first quarter of 2008."

Slovakia's October CPI also showed a significantly higher-than-expected rise of 0.6% on month, meaning the 12-month rate accelerated to 3.3% from 2.8% in September. "Food prices with growth of 2.6% on month and a contribution of 0.41 percentage point were the main driver," says Miroslav Frayer, economist with Komercni Banka. This comes at an awkward time for Slovakia as it tries desperately to meet the criteria necessary to join the European single currency and become the Eurozone's 14th member.

The Czech Republic's October CPI rose by 0.6% on month and 4.0% on year, with the main drivers being prices for food (prices of milk increased 14.8% on month, unsalted butter 15.0% and flour 11.9%) and gas. October's annual growth of food prices reached 6.3%, fuel price growth was 3.9% and regulated prices went up 12.9%. "Another strong acceleration in inflation should show up at the beginning of next year, ie. toward 5.5% in the first quarter of 2008. The risk of even higher growth next year lies in food prices and fuel prices," says Jiri Skop, an economist with Komercni Banka.

Bulgaria managed to buck the regional trend, with its CPI rising by 12.4% on year in October, slightly slower than the previous month thanks to falling prices for some foodstuffs. However, with its inflation rate at 13.1% in September, Bulgaria had the highest rate of all 27 EU member states, so its position is hardly reassuring.

The challenge

Emerging Europe has benefited hugely since the turn of the century from strong growth coupled with low inflation. That has now undoubtedly changed, presenting the monetary authorities with a big challenge ahead. "The inflation fighting regimes in these countries are much younger and to a large extent untested," says Brian Coulton, managing director of Fitch Ratings in London. "If they don't handle this well, then it will be a big challenge for their credibility."

What are the policy implications of rising food prices and what effect will these policies have on the region's economies? Certainly, more interest rate hikes - or the postponement of further cuts - that could, by some estimates, take as much as 1.5% annually off GDP growth. "A very rough estimate of how much this could take off GDP growth in the coming years is 1 to 1 1/2% annually," reckons Bank Austria Creditanstalt's Quijano-Evans.

Economists say that countries with stronger economic growth and tighter output gaps are more at risk of food price inflation spilling over into core inflation. The structure of growth is also important and here Romania and to a lesser extent Poland are more at risk of inflation given the strength of domestic demand growth in relation to overall GDP growth. Romania and Poland are most susceptible, therefore, to food prices spilling over into central bank policy.

The National Bank of Romania (NBR) in particular has a challenge ahead of it. At its meeting October 31, the NBR raised the main policy rate by 50 basis points to 7.5% and introduced more hawkish rhetoric about inflationary risks and the increasing vulnerability of its external financing position as the current-account deficit balloons to a forecasted 13.5% of GDP this year. However, the NBR has an inflation target that this hike will do little to help meet. "The next board meeting is not until January, but the NBR may have to react in advance with rate hikes in order not to lose credibility," reckons Quijano-Evans.

The CPI rise in Poland will almost certainly result in another quarter-point interest rate increase by its central bank at the next meeting on November 28. And in Bulgaria and the Baltic states - which have current-account deficits of more than 12% - the increasing external debt/GDP ratio will require some form of policy action. "This means stricter fiscal and monetary policy, which will hit growth in the medium term," says Quijano-Evans. "Romania can be added to the list, given the low FDI to current-account coverage ratio and inflation target."

Hungary and Turkey, on the other hand, are in easing cycles.

Hungary, a standout in the region for its anaemic growth rate as the government implements a series of austerity measures to fix the country's dire fiscal position, is now very unlikely to see any interest rate cut at the next meeting November 26, and the probability of a December 17 cut has also decreased. "The room for rate cuts has definitely narrowed - [we] expect only a 50-basis-point rate cut versus a previous estimate of 100 basis points on a 12-month horizon," say analysts at Raiffeisen.

Turkey's central bank on November 15 cut the overnight borrowing rate for the third consecutive month by 50 basis points to 16.25%. Despite the risks regarding food and energy prices, the central bank's policymaking committee said inflation would continue falling on the back of the delayed effects of monetary tightening. As such, Oyak Securities says it expects the central bank to slow down the easing cycle at the December meeting and cut the overnight rate by 25 basis points.

Such a move would be welcomed by the International Monetary Fund (IMF), whose mission chief to Turkey, Lorenzo Giorgianni, said on a conference call on November 19 that rate cuts should be moderate and in line with the improvement in inflation and inflationary expectations.

"We totally agree with IMF's view that the central bank should maintain a gradual monetary policy easing, since Turkey is still far from its ambitious inflation target of 4%," says Raymond James Securities in Istanbul.

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