Neil Shearing of Capital Economics -

• Falling food and energy prices, combined with weaker economic growth, mean that inflation in Central Europe could be about to collapse. But much will depend on developments in the currency markets.

• The inflation outlook in Poland, Hungary and the Czech Republic has improved dramatically. Oil prices have fallen from their summer highs and regional crop harvests have recovered strongly after last year's drought. Accordingly, domestic energy and food prices could soon fall sharply. If oil prices to drop to $80 per barrel by end-2009, headline inflation in the region could fall by just over 1%. And even if food prices simply stagnate, that could be enough to knock another 0.5% off inflation.

• At the same time, growth looks set to slow in Poland and the Czech Republic as demand from the Eurozone cools. Likewise, the nascent recovery in Hungary could soon run out of steam. As a result, capacity pressures should start to ease.

• The combination of falling commodity prices and rising capacity should pave the way for a sharp drop in inflation. Sceptics would argue that inflation expectations are not firmly anchored, which is true, particularly in Hungary. But even so, developments in the currency markets are likely to be the biggest barrier to a sharp fall in inflation.

• The currencies of Central Europe gained by between 7% and 12% against the euro in the first half of the year (see chart 1). This acted as a powerful brake on inflation. But as we have noted before, the currency rally went beyond what was supported by fundamentals and the near-term risks to exchange rates in the region may now be on the downside.

• We estimate that a 10% drop in the currencies of all three countries against the euro would be sufficient to wipe out all of the on inflation stemming from a drop in oil prices to $80 per barrel. The outlook for inflation in the region therefore hinges on developments in the currency markets, which are of course highly uncertain. Nonetheless, that doesn't prevent us from making an informed judgment.

• The koruna is arguably backed by the strongest fundamentals - at just under 2% of GDP, the Czech Republic has the smallest current account deficit of all three countries and it is fully backed by foreign direct investment (FDI). By contrast, the forint is supported by the weakest fundamentals: while Hungary's current account deficit has contracted recently, it remains large and, crucially, the political outlook remains highly uncertain. Finally, Poland's current account deficit is rising, but remains well covered by FDI and improved investor sentiment following the government's decision to target EMU entry in 2012 should help support the zloty.

• As such, there is greatest scope for a sharp fall in Czech inflation (see chart 2). By contrast, inflation in Poland may not fall as fast; the currency may benefit from improved investor sentiment, but capacity pressures are more acute. Finally, a combination of external vulnerabilities and stubbornly high inflation expectations mean that Hungary is less likely to experience a sharp drop in inflation. That in turn means that policymakers will adopt a far more cautious approach to cutting interest rates.

Neil Shearing is Emerging Europe Economist of Capital Economics

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