Tightening labour markets in central Europe are giving rise to higher wage settlements and bringing to an end years of employment slack, according to research by Medley Global Advisors, a macro intelligence service owned by the FT.
Rising labour costs, in the absence of matching productivity gains or cuts in profit margins, could lead to upside risks to inflation that will force the region’s central banks to act.
The National Bank of Romania has the most pressing decisions to make, contending with an economy that looks to be overheating and an inflation rate that is set to return to target over the coming year as value added tax cuts drop out of annual price comparisons.
Gross domestic product grew by 5.2 per cent in the first half of the year, driven by household spending from double-digit wage growth and lower indirect taxes. The consumer boom will continue over the coming year and, as the NBR has highlighted, is reinforced by a comparatively loose fiscal policy, with a budget deficit of about 3 per cent of GDP this year and next.
The NBR cut its policy rate to 1.75 per cent in May 2015, but Mugur Isarescu, the hawkish governor and 25-year veteran of the central bank, refused to pander to political demands for even lower rates. The bank rightly argued that annual declines in inflation were temporary and driven by sizeable cuts in VAT.
The consumer price index declined by as much as 3.5 per cent in the year to May 2016 but, as some of the VAT cuts from the previous 12 months dropped out of the annual comparison, the rate of deflation has slowed to 0.2 per cent year-on-year.
By the start of 2017, inflation will be back into positive territory and, fuelled by strong demand, it will move into the middle of the NBR’s 1.5-3.5 per cent target range by the middle of next year. This will force the central bank’s hand: the first rate rise will come in the spring, with the policy rate heading towards 2.5 per cent by end-2017 / early 2018.
The National Bank of Poland is some way behind in contemplating tightening. However, Adam Glapinski, the new governor, said last week there was “no temptation” to reduce interest rates further — the repo rate stands at 1.5 per cent — removing any residual market pricing that interest rates could be cut again this year or next.
He went further, in stating that the NBP was moving towards interest rate increases and would have to think at what point near the end of next year it would need to make its first upward move.
This all presupposes that the economy picks up after a slightly disappointing start to this year. GDP increased by 3.1 per cent year on year in the opening six months — an outcome depressed by the slower dispersion of EU grants.
But EU-funded investment projects will pick up, adding an estimated one percentage point to annual GDP growth. In addition, consumer spending will receive a boost from the second half of this year, as the full effect of the “500+” child allowance kicks in, and from very buoyant wage growth now running at 5-6 per cent year on year in real terms.
In what has become a tight labour market, with reports of skills shortages in areas such as construction, wage pressures and strong demand could yet feed through to higher consumer prices faster than the market anticipates.
The NBP’s record on forecasting higher inflation is not great but its latest predictions show the start of a return to positive annual numbers in January next year (from -0.8 per cent year on year at present), leading to 1 per cent or so by end-2017 and back into the 1.5-3.5 per cent target range in 2018.
Mr Glapinski, the driving force of the new monetary policy council, favours an initial interest rate move once economic growth gathers momentum from renewed EU funding. This would also be conditional on the bank’s projections showing inflation heading back into the NBP’s target range over subsequent quarters.
This implies a modest rate rise in late 2017, with the rider that it could slip into 2018 if the economy disappoints.
The National Bank of Hungary (MNB) resumed its salami slicing approach to lower interest rates back in March, reducing the base rate in three further moves of 15 basis points a piece to 0.9 per cent. This is as low as it will go on official interest rates but monetary policy will remain accommodating, with the bank now concentrating on unconventional measures.
The MNB is keen to encourage commercial banks to boost lending rather than park spare cash at the central bank, as has tended to be the case in the past. Its intention is to push money market rates and bond yields lower, in theory making it more attractive for companies to borrow and invest.
The central bank will now accept less cash from the commercial banks through its three-month deposit facility. It hopes that surplus funds will be used to boost credit or filter into the money markets and drive down short-end rates, possibly by 30bp-40bp, from about 0.9 per cent at present.
This accommodative policy is set against a background of slower economic growth than policymakers would like. GDP increased by less than 2 per cent year on year in January to June with more recent indicators pointing to only a modest expansion in the key manufacturing sector.
Despite the unemployment rate dropping to 5 per cent, the MNB believes — somewhat complacently — that inflation (running at -0.1 per cent year on year in August) will be below its 2-4 per cent target at least until the end of next year, and that official rates can remain on hold throughout the next two years.
The Czech National Bank’s actions of capping the currency against the euro on the weaker side of 27 will stay in place at least until the middle of next year. At the same time, Jiri Rosnok, the new governor, is backing away from moving to a negative policy rate — the repo rate has remained at just 0.05 per cent since late 2012 — for as long as monetary conditions are not loosened further in the Eurozone.
A focus on interest rates as the key policy tool in the Czech Republic will only re-emerge when rates in western Europe are on the upturn and inflation is back within the CNB’s 2-4 per cent target range. Neither looks likely soon, with the ECB at best on hold and Czech inflation continuing to lounge some way below target at 0.6 per cent year on year.
Domestic price pressures are positive, not least from rising wages, but this is counteracted by weak raw material prices and a firm currency — producer prices have been falling in annual terms for the past two-and-a-half years and were down 4 per cent year on year in the latest month.
Even when consumer price inflation rises, the act of removing the FX cap, with the possibility of pent-up demand driving up the koruna against the euro and tightening monetary conditions, could be justification for the CNB keeping interest rates lower for longer.
Dan Bogler is a commissioning editor at Medley Global Advisors.
Follow us on Twitter @em_sqrd