Supply shocks help to tear down legacy of the iron curtain

Economic differences across Europe will start to level out

From Szczecin on the Baltic Sea, a curtain has descended southwards across the European continent. Unlike its iron predecessor, it divides Europe in terms of inflation, with eastern Europe experiencing higher inflation rates.

The original curtain divided Europe both politically and economically. The countries in the East were cut off from their economic links to the West and focused mainly on energy-intensive industry. Due to the slow growth that characterised their centrally planned economies, central and eastern European countries were much poorer when the curtain fell in the early 1990s. Although their standard of living has risen remarkably over the last 30 years, they still lag western Europe.

As a result, the general price levels in CEE countries in 2021, before the worst energy shock in decades hit, was 30% below the European Union average. The price differences were largest in the services sector, reflecting lower wages, which were about 40% below the EU average. Lower wages mean that the share of tradable goods, which were most affected by the global supply shock, is higher in the consumer basket; the same increase in energy or food prices subsequently leads to higher headline inflation.

More interesting is the question of what the different price levels mean for core inflation, which in 2023 averaged 9% in CEE countries, 5% in Germany and 4% in France. As economists, we often overlook a simple fact: inflation is the percentage change in the price level and its value therefore depends on initial prices.

Put simply, the same shock (expressed in euros) has a bigger impact on inflation (expressed in percent) in the country where the price level is lower. For example, if restaurants’ food and energy costs go up by €1 per lunch globally, the impact on inflation is greater in countries where the cost of lunch rises from €5 to €6 (by 20%) than in those where it rises from €10 to €11 (by 10%).

Another factor that is often overlooked is the higher energy intensity of CEE economies. If you need more units of electricity or gas to produce one unit of output, this must translate into higher inflation if input costs rise at the same rate.

Effects of supply shocks exacerbated by lower price levels

What do these overlooked factors mean for macroeconomic policy? First, the usual assumption that higher core inflation signals a more overheated economy might no longer hold after a supply shock. Of course, other factors have played a role. Labour market tightness, fiscal support and the degree of competition between market players have influenced the extent to which companies have been able to pass on their increased costs to consumers. However, we have found that differences in price levels explain almost 50% of the variation in core inflation after large supply shocks (2008 and 2022), while their explanatory power in other years is negligible.

As the effect of the cost shock on the price level is now fading, core inflation is once again reflecting the strength of the domestic economy. We can already see this in the published inflation data for January. Price level and energy intensity differences are playing less of a role and core inflation in CEE countries has moved closer to the EU average. Last January, CEE countries occupied all top 10 places in the core inflation ranking. This year, Austria, Sweden and Belgium are in the top 10. Czechia, which had the second highest core inflation last January, has dropped to 11th place this year.

Figure 1. EU countries and Switzerland ranked by inflation

A country’s ranking in a given inflation category, from highest to lowest

Source: Eurostat, Czech National Bank

Second, the monetary policy restriction required to tame inflation after a large supply shock may not be as severe as in the case of demand-driven inflation. We see this in the example of the Baltic States, where core inflation started to fall in October 2022, even before the effects of the European Central Bank’s tightening were felt (the ECB deposit rate was still at zero in July 2022).

Third, excessively tight monetary policy could even be an obstacle to curbing inflation in the future. CEE countries need to invest in energy efficiency and state-of the-art technologies. Too high interest rates could slow down these investments and maintain the suboptimal state of the economy (in the same way that too low interest rates keep zombie companies undead).

Finally, the role of different price levels will diminish over time as countries with lower price levels catch up with the West. What we are seeing now – higher inflation in lower-income countries – can be seen as a sign of convergence accelerated by supply shocks. Higher service prices may indeed mean higher wages in the service sector. To some extent, higher wages and service prices act as a buffer, shielding inflation from supply shocks – just look at the inflation rate in Switzerland.

Although it is unlikely that wages in CEE countries will fully equalise with those in Switzerland or other rich western economies, we believe that the economic legacy of the iron curtain will eventually disappear from the map of Europe.

Tomáš Adam is Adviser to the Governor of Czech National Bank and Jiří Schwarz is Adviser to the Board of the CNB and Dean of School of Business Administration at Anglo-American University, Prague.

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