Though fears of a double-dip recession have not entirely vanished, the global economy is on its way to recovering from the deep downturn. Fiscal and monetary stimuli to boost activity are gradually being withdrawn as economic growth gets back on track and the time arrives to consolidate public finances.
Meanwhile monetary conditions should be tightened to prevent the creation of asset price bubbles that may arise when credit is cheaply available. Thus Central and Eastern European countries should also face the necessity to rein in widening budget deficits and tighten monetary policies by raising official rates (in many cases at historic lows at present) when appropriate.
CEE not in lock step
Despite many similarities, even those Central and Eastern European countries that operate floating exchange-rate regimes (and thus use interest rates as their main monetary policy tool) differ from each other in several ways.
Poland has a large internal market that enabled it to partially offset the adverse effects of collapsing external demand even at the climax of the financial crisis, eventually avoiding recession.
The Czech Republic’s export-oriented economy reacted more sensitively to difficulties on its Western European markets, but its sound financial system insulated the country from a possible outright currency crisis and it was also successful in benefiting from countercyclical fiscal measures introduced in Germany, its largest trade partner.
Hungary and Romania had neither the big domestic market nor sound financial systems to fall back on and suffered a huge fall in their output. To avoid financial collapse in the wake of the liquidity squeeze they had to apply for assistance from international lenders, namely the International Monetary Fund, European Union and other sources.
While markets more or less grew confident about the fiscal consolidation plans - though less so in the case of Hungary and Romania - they remain uncertain when the first rate rises will be. Things look simplest in the two fundamentally strongest economies of the region, the Czech Republic and Germany.
The Czech Republic has just left its main two-week repo rate at the historic low of 0.75%, when markets were in fact expecting to see a further cut rather than a rise due to the recent appreciation of the koruna. However, with the solid performance of the German economy probably not even such a strong koruna will harm Czech exports, while in the latest Inflation Report of the Czech central bank - published at the same time as the rate decision - inflation was also dismissed as a threat in the short run. We thus believe that the Czech base rate will remain unchanged in 2010.
Poland has also experienced a substantial firming of the zloty recently but with a planned VAT rise to cut the budget gap it would bode ill to trim the base rate further from its historically low 3.50%. Inflation is expected to catch up from August anyway, while the current setup of the Monetary Council is perceived to be more hawkish than its predecessor. Thus with price pressure mounting towards the end of the year we expect a minimal rate rise of 25bps, or basis points, possibly in October.
Little room for easing in Hungary
For economies deemed to be in worse shape than their regional peers, the interest rate outlook is more obscure. Hungary’s easing cycle has still not been declared at an end, however, since the ill-timed comments about the budget by ruling party politicians in June gave the central bank (MNB) hardly any opportunity to cut the base rate further from 5.25% - which, by the way, is also an historic low.
In addition the suspension of talks with international lenders the IMF and EU in July kept Hungary’s risk perception high, as reflected by the country’s five-year Credit Default Swap spreads that decoupled from the region. Yet against this background investor demand still remained high for government securities, leading to lower yields on recent auctions. The inflation outlook also remains benign, with a sharp drop expected from July when the effects of the VAT rise implemented last year will disappear from the annual figures.
Thus, despite inherent risks that led many market analysts to project a base rate rise soon, we do not expect the MNB to begin tightening monetary conditions this year.
Inflation worries in Romania
Romania is in a somewhat comparable situation because the general economic outlook would also allow for the monetary easing cycle (which saw the base rate reduced to the current 6.25%) to be continued. However, fiscal austerity measures that also come with a five percentage point rise in VAT may lift inflation considerably. While such an effect should not necessarily be taken into account by the monetary authority, Romania is notorious for very high inflation inertia, Thus expectations are very sticky and even a VAT rise could create strong second-round inflationary effects.
The Romanian central bank (BNR) will probably wait for some time to evaluate these effects but the chance for further rate cuts is seen to be very low. However, a rate rise will also come hard because the fiscal austerity measures adopted to comply with the required deficit figures in the IMF-led rescue package clearly dent Romania’s hopes for coming out of recession soon. Thus the BNR will try to avoid tightening the monetary conditions unless it is forced to by a possible deterioration in investor sentiment. All in all, with higher than usual uncertainty we continue to expect no change in the Romanian base rate until the end of 2010.
As a somewhat surprising conclusion, we expect that it will be the Polish central bank that begins to raise its policy rate first in Central and Eastern Europe