## Inflation Dynamics in Bulgaria: The Role of Policies

## Source details

**Canonical URL:** [Inflation Dynamics in Bulgaria: The Role of Policies](https://www.imf.org/-/media/files/publications/wp/2023/english/wpiea2023212-print-pdf.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/wp/2023/english/wpiea2023212-print-pdf.pdf.md)
- [Structured JSON version](/-/media/files/publications/wp/2023/english/wpiea2023212-print-pdf.pdf.json)

---

### Introduction — Context and Research Questions
- Background quotes preserved:
  - “Inflation is always and everywhere a monetary phenomenon” — Milton Friedman, 1963
  - “Persistent inflation is always and everywhere a fiscal phenomenon” — Thomas Sargent, 2013
- Observations:
  - Inflation in Bulgaria peaked above 15 percent in 2022, marking its highest level since 2000 and has been relatively persistent, fading away only gradually over subsequent periods.
  - The sudden rise in inflation after being low and stable for long was not limited to Bulgaria; it affected many countries around the globe, both advanced economies and emerging markets.
- Research questions:
  - (1) Are there country-specific factors given the seemingly global nature of inflation?
  - (2) How persistent is the inflation dynamics in Bulgaria?
  - (3) Did policy contribute to the recent surge in inflation?

### Methodology — Econometric and Accounting Approaches
- Methods used:
  - Principal component analysis to shed light on the potential interplay between common and country-specific factors affecting inflation dynamics.
  - Estimation of Phillips curves for Europe as a whole and Bulgaria individually.
  - Breakdown of changes in GDP deflator into unit profits and unit labor costs based on a GDP accounting identity.
  - Development of a measure to capture the loosening/tightening of the ECB’s monetary policy stance for Bulgaria building on the literature.
  - Estimation of a structural VAR model, which explicitly identifies fiscal and monetary policy shocks and quantifies their contributions to inflation in Bulgaria.
- Rationale:
  - Use of a variety of complementary econometrics technics intends to test the robustness of findings.

### Key Findings — Summary
- Common vs country-specific factors:
  - Common factors explain a large share of inflation variations in the EU but translate to inflation in individual countries with varying degrees, reflecting the role of country-specific factors.
  - Greater weights of energy and food in Bulgaria’s HICP basket amplifies the impact of shocks on headline inflation.
  - The increase in core inflation in Bulgaria was more pronounced than in the EU.
- GDP deflator decomposition:
  - GDP accounting identity indicates a quick pass-through of supply shocks at the beginning of the inflation surge, followed by an increasing role of the labor market dynamics more recently (similar to the finds of Blanchard and Bernanke (2023) for the US).
- Phillips curve and persistence:
  - Second-round effects in Bulgaria might be stronger than in the EU, as indicated by a greater persistence of core inflation and a higher contribution of economic slack.
- Role of policies:
  - Recent ECB monetary tightening has been insufficient for Bulgaria and its transmission is weak.
  - Fiscal policy in Bulgaria supported COVID-19 recovery but made a non-negligible contribution to inflation.

### Recent Inflation Developments in Bulgaria (Section III)
- HICP inflation:
  - soared to 15.6 percent year-on-year (y-o-y) in September 2022.
  - decelerated to 7.5 percent y-o-y in June 2023.
  - Bulgaria’s consumer price increases were the 10th largest in the EU.
- Cross-country divergence:
  - Relative price developments produced growing divergence with best performers in Europe.
- Producer and import price dynamics:
  - Import prices inflation peaked at 22 percent in the second quarter of 2022.
  - Domestic producer price index (PPI) inflation soared to almost 80 percent in September 2022.
- Commodity price drivers:
  - Energy prices inflation reached around 41 percent in the EU and 37.5 percent in Bulgaria in June 2022.
  - Food prices peaked at 22 percent in Bulgaria (November 2022) and almost 17 percent in the EU (March 2023).
  - Contribution of food prices to headline inflation reached 6.4 ppt in Bulgaria and 3.7 ppt in the EU.
  - Energy contribution to headline inflation was similar in Bulgaria and the EU during the peak episode.
- Breadth of inflation:
  - By end-2022, double-digit inflation was recorded in around 65 percent of the HICP commodity groups (at 4-digit level) in Bulgaria, compared to 35 percent in the EU on average.
- Core inflation:
  - Core inflation in Bulgaria was 11.1 percent y-o-y at end-2022 versus 6.2 percent y-o-y in the EU at the same time.
  - Core inflation in Bulgaria rose with lags following headline inflation and has remained elevated despite headline deceleration.

### Principal Component Analysis (PCA) — Contributing Factors
- Co-movement statistics:
  - Average bilateral correlation between q-o-q seasonally adjusted annualized national inflation rates (2007 onward) across EU27 is 0.71.
  - Average bilateral correlation limited to CESEE EU members is 0.76.
  - Correlation for core inflation across the EU is 0.60.
- PCA results:
  - Over two thirds of the variance in inflation in EU member states can be explained by a single principal component.
  - The first principal component explains close to 73 percent of the variance in headline inflation and around 66 percent of the variance in core inflation.
- Country-specific vs common components:
  - The recent surge in headline and core inflation since 2021 is driven by the single principal component (common shock).
  - The idiosyncratic (country-specific) component for Bulgaria has been negative during the surge period.
  - Bulgaria’s factor loading on the first principal component is relatively high, and for core inflation it is higher than for headline inflation.
- Cross-country heterogeneity:
  - Factor loadings are generally higher in Baltic countries, Hungary, Czech Republic, and Bulgaria; lower in France, Finland, Malta, and Sweden.
  - Factor loadings in CESEE countries display high correlations with the share of food and energy in consumer baskets (correlations above 0.70 for both headline and core inflation).
  - Factor loadings exhibit an inverse relationship with the size of the economy (-0.38 with headline inflation and -0.47 with core inflation).
  - Trade openness was not a significant correlate of factor loadings in the analysis.

### GDP Deflator Decomposition and Phillips-Curve Evidence
- Decomposition approach:
  - Changes in the GDP deflator are decomposed into unit profit, unit labor cost, and unit tax contributions using the income side of GDP.
- Unit profits and labor costs:
  - Unit profits did not play a large role prior to 2021; they rose in 2021 and the first half of 2022 reflecting pass-through of higher input costs.
  - Contribution of unit labor costs remained muted in 2021 while employment support schemes were in place.
  - Unit labor costs contributed significantly to the increase in the GDP deflator in 2022 as wage increases outpaced productivity growth, particularly in the private sector.
- Labor market and second-round effects:
  - Data suggest gradual labor market tightening and a possible steepening of the inverse relationship between core inflation and unemployment rate during the recent inflation surge.
- Overall interpretation:
  - Initial inflation surge largely driven by common external supply-side shocks; second-round effects—through profits and wages—contributed to sustaining inflation.

### Phillips-Curve Estimation and Inflation Persistence (2000Q1–2022Q4)
- Sample and specification:
  - Dependent variable: core HICP (excluding energy, food, alcohol, and tobacco).
  - Regressors include lagged core inflation, one-year ahead inflation expectations (Consensus forecasts), unemployment gap (deviation from HP-filtered unemployment), lagged external price pressure, and measures of food and energy prices.
  - Estimation: panel regressions for European, Advanced European (AE), and Emerging European (EE) economies; OLS for Bulgaria (BGR).
- Selected coefficients (preserved exact figures):
  - Unemployment gap:
    - EUR: -0.258***
    - EE: -0.567***
    - AE: -0.106
    - BGR (Column 4): -0.384*
    - BGR (Column 5): -0.377
    - BGR (Column 6): -0.222
  - Lag of core HICP inflation:
    - EUR: 0.341***
    - EE: 0.435***
    - AE: 0.238*
    - BGR (Column 4): 0.676***
    - BGR (Column 5): 0.678***
    - BGR (Column 6): 0.826***
  - Inflation expectations, 1 year ahead:
    - EUR: 0.607***
    - EE: 0.475***
    - AE: 1.011***
    - BGR (Col 4/5): 0.276*** / 0.268***
  - External price pressure (t-1):
    - EUR: 0.028***
    - EE: 0.047***
    - AE: 0.013*
    - BGR: 0.020 / 0.018 (not statistically significant)
  - Export share-weighted food price inflation (contemporaneous for BGR): 0.054** (with lagged terms mixed)
- Observations and fit:
  - EUR panel observations: 2,552; R-squared: 0.734; country FE: Yes.
  - EE panel observations: 530; R-squared: 0.832; country FE: Yes.
  - AE panel observations: 2,022; R-squared: 0.479; country FE: Yes.
  - BGR OLS observations: 88 (Cols 4–5) and 62 (Col 6); R-squared: 0.855, 0.857, 0.825 respectively.
- Interpretation:
  - Past core inflation is a very important driver of current core inflation in Bulgaria, with estimated coefficients much larger for Bulgaria than for European panels.
  - Strong persistence suggests inflation expectations in Bulgaria might be largely backward-looking.
  - The Phillips curve appears to have steepened since mid-2021, indicating shrinking slack played a greater role during the inflation surge.

### Monetary Policy — Transmission under the Currency Board
- Institutional context:
  - Bulgaria operates a long-running currency board with the euro; the BNB does not set a policy interest rate under the currency board.
  - ECB monetary policy influences Bulgaria via deposit and interest rates, external demand, effective exchange rate vis-à-vis non-euro area countries, import prices, and capital flows.
- Taylor-rule assessment:
  - A Taylor-rule implied policy interest rate for Bulgaria is derived using average parameters from euro-area studies and Bulgaria’s output gap.
  - The difference between the actual ECB deposit rate and the Taylor rule-based interest rate indicates ECB’s policy was too accommodative for Bulgaria in 2021–22 and remains so as of mid-2023.
  - Caveat: Taylor rule parameters apply to euro area; neutral rate for Bulgaria likely higher, so estimated Taylor rule-based rate may be lower than appropriate for Bulgaria.
- Transmission issues and evidence:
  - 3-Month EURIBOR increased in line with ECB policy rates since July 2022.
  - Interest rates on retail deposits in Bulgaria remained low despite ECB policy rate increases, reflecting abundant banking-sector liquidity.
  - Interest rates on new loans to nonfinancial corporations in Bulgaria have increased less than in the euro area; interest rate on new mortgage loans to households in Bulgaria has hardly increased while euro-area mortgage rates have jumped.
  - Low funding costs and strong competition for credit market share have underpinned slow transmission of ECB tightening.
- BNB tools within the currency board:
  - Minimum required reserves (MRR) rate: BNB sets MRR; higher unremunerated MRR increases banks’ funding costs and is expected to exert upward pressure on lending rates.
  - In June and July 2023, BNB increased MRR from 5 percent (liabilities to nonresidents) and 10 percent (residents) to 12 percent (for both) in two steps.
  - Interest on excess reserves: remunerating excess reserves could encourage banks to hold liquidity at the BNB, but BNB historically did not remunerate excess reserves due to potential cost increases.

### Fiscal Policy — Structural VAR Analysis and Effects
- VAR specification and identification:
  - Endogenous variables: real GDP growth (log difference), core inflation (excluding energy and unprocessed food), short-term interest rate, and primary fiscal balance in percent of GDP (previous quarter).
  - Sample: 2004Q1–2022Q4; baseline model uses four lags; primary balance moving-averaged over four quarters.
  - Fiscal shock identification: sign restrictions such that a tightening fiscal policy raises primary balance but lowers GDP growth or inflation (contemporaneous sign restrictions only).
- Impulse-response summary:
  - A one-standard-deviation unexpected expansionary fiscal shock reduces the primary balance by 0.45 percent of GDP while increasing annual output growth.
- Fiscal shock effects and fiscal multiplier:
  - A simulated fiscal expansion raises output by 0.5 percent, implying a fiscal multiplier of 1.
  - Annual inflation increases by 0.2 percentage points following the fiscal shock, with effects fading only gradually.
  - Forecast error variance decomposition: fiscal policy shocks explain about 15–25 percent of inflation variation on average, with larger explanatory power in the short term.
- Historical contributions (COVID-19 period):
  - 2020: model attributes the significant drop in output growth mainly to non-fiscal shocks; negative contribution of fiscal policy suggests fiscal support in 2020 was relatively smaller than the severity of the shock.
  - 2021: fiscal support (beyond endogenous response) is estimated to have contributed 2.8 percentage points to output growth, almost 40 percent of total output growth.
  - 2022: fiscal policy added about 1 percentage point of output growth (total effect including lagged effects).
  - Inflation contributions:
    - Fiscal shocks explain about 1.2 percentage points of inflation in 2021.
    - Fiscal shocks explain about 3 percentage points of inflation in 2022.
- Mechanism:
  - Impact of fiscal policy on output growth fades quickly, while its impact on inflation is persistent; lagged fiscal supports implemented at end-2021 produced significant positive inflation effects in 2022.

### Extended VAR and Euro Area Monetary Policy
- Extended model:
  - Adds a measure of EA monetary policy stance: the interest rate gap between actual ECB interest rate and a Taylor-rule based rate.
  - Identification imposes sign restrictions where a positive EA monetary policy shock increases the ECB Taylor gap, puts upward pressure on Bulgaria’s short rate, and lowers inflation and output growth contemporaneously.
- Extended model results:
  - Fiscal policy contribution to inflation in 2022 remains robust but slightly smaller at 2.5 percentage points.
  - Too-loose ECB monetary policy stance contributed about 1 percentage point to inflation in Bulgaria in 2022.

### Sensitivity Analyses and Robustness Checks
- Alternative fiscal indicators examined: primary balance excluding grants, cyclically-adjusted primary balance excluding grants, overall balance in cash, overall balance in accrual — results similar; contribution of fiscal policy to inflation slightly larger when using overall balance in accrual.
- Alternative interest rate measures considered: interbank money market overnight rate (baseline), short-term interest rate (OECD), rate of less-than-one-year deposits, and government bond yield for newly issued bonds with maturity over a year — results corroborate fiscal contribution to inflation, particularly in 2022.
- Pre-COVID sample (2004Q1–2019Q4) yields similar results, indicating stability of model parameters.
- Phillips-curve robustness:
  - Extensions and checks in Annex I confirm persistence of inflation dynamics.
  - Sensitivity includes controlling for time and fixed effects, cross-dummies for specific subperiods, restriction on sum of coefficients on past and expected inflation, and alternative unemployment-gap measures — findings are similar.
  - Medium-term (three-year) inflation expectations are stable around 2.5 percent in recent inflation surges.

### Policy Implications and Conclusions
- External factors (supply-chain constraints, commodity and food price shocks, synchronized policy supports) played an important role in Bulgaria’s inflation dynamics; country-specific factors (larger weight of energy and food in CPI) amplify headline inflation.
- Second-round effects appear stronger in Bulgaria due to greater core inflation persistence and an increasing role of economic slack.
- ECB monetary tightening appears to have been insufficient for taming inflation in Bulgaria, aggravated by weak monetary transmission given significant liquidity and strong competition in the banking sector under the currency board.
- Fiscal policy, while supporting rapid recovery, likely contributed to the inflation surge; this underscores the importance of fiscal policy discipline and liquidity management in managing inflation risks in Bulgaria given the currency board arrangement.
- Suggested avenues for future research:
  - Using narrative approaches to identify fiscal shocks.
  - Studying nonlinearity in policy-inflation relations across business-cycle phases.
  - Quantifying differential effects of various types of ECB monetary shocks (short-term rate changes, forward guidance, quantitative easing) on Bulgaria’s inflation dynamics.

*Source: IMF Working Paper No. WP/2023/212 (wpiea2023212-print-pdf).*

### REFERENCES _____________________________________________________________________________________ 28

### REFERENCES

### Figures and Tables Inventory
- Figures listed (with exact titles and numbering):
  - 1. Inflation in EU Countries
  - 2. Maastricht Criterion on Inflation
  - 3. Global Food and Energy Prices
  - 4. Producer and Consumer Prices in Bulgaria
  - 5. Contribution to Annual HICP Inflation by Commodity Groups in Bulgaria and EU
  - 6. Inflation in Unprocessed and Processed Food and Core Inflation in Bulgaria and EU
  - 7. Histogram of the Bilateral Correlations of the National Inflation Rates in the EU.
  - 8. Decomposition of Headline and Core Inflation in Bulgaria by Common and Country-Specific
  - 9. Factor Loadings in the First Principal Component for Headline and Core Inflation
  - 9. Factor Loadings in the First Principal Component for Headline and Core Inflation
  - 10. Bulgaria: Decomposition of GDP Deflator
  - 11. Bulgaria: Core inflation (exc. Taxes) and
  - 12. Difference Between ECB Policy Rate and Taylor Rule-Implied Interest Rate
  - 13. ECB Policy Rate and Costs of Funding
  - 14. Bulgaria: Banking Sector Liquidity and Interest Rates on Household Deposits
  - 15. Interest Rates on Loans to Nonfinancial Corporations
  - 16. Bank Interest Rate on New Mortgages
  - 17. Fiscal Stance in 2021 and Inflation in 2022 in EU Countries
  - 18. Impulse Response to a One-Standard-Deviation Expansionary Fiscal Shock
  - 19. Forecast Errors Variance Decomposition of Inflation
  - 20. A Decomposition of Recent Output Growth and Inflation Dynamics
  - 21. A Decomposition of Inflation Dynamics in an Extended Model

- Tables listed (with exact titles and numbering):
  - 1. Decomposition of the Contribution of Major Product Groups to Inflation in Bulgaria and EU in July 2023
  - 2. Estimated Phillips Curve
  - 3. Taylor Rule Parameters

- Annexes listed:
  - I. Phillips Curve Estimates- Extension
  - II. VAR Model
  - III. Sensitivity Analyses

### Introduction — Context and Research Questions
- Background statements quoted:
  - “Inflation is always and everywhere a monetary phenomenon” — Milton Friedman, 1963
  - “Persistent inflation is always and everywhere a fiscal phenomenon” — Thomas Sargent, 2013
- Observations:
  - Inflation in Bulgaria peaked above 15 percent in 2022, marking its highest level since 2000 and has been relatively persistent, fading away only gradually over subsequent periods.
  - The sudden rise in inflation after being low and stable for long was not limited to Bulgaria; it affected many countries around the globe, both advanced economies and emerging markets.
- Research questions addressed:
  - (1) Are there country-specific factors given the seemingly global nature of inflation?
  - (2) How persistent is the inflation dynamics in Bulgaria?
  - (3) Did policy contribute to the recent surge in inflation?

### Methodology — Econometric and Accounting Approaches
- Methods used (exact phrasing preserved):
  - Principal component analysis to shed light on the potential interplay between common and country-specific factors affecting inflation dynamics.
  - Estimation of Phillips curves for Europe as a whole and Bulgaria individually.
  - Breakdown of changes in GDP deflator into unit profits and unit labor costs based on a GDP accounting identity.
  - Development of a measure to capture the loosening/tightening of the ECB’s monetary policy stance for Bulgaria building on the literature.
  - Estimation of a structural VAR model, which explicitly identifies fiscal and monetary policy shocks and quantifies their contributions to inflation in Bulgaria.
- Rationale:
  - Use of a variety of complementary econometrics technics intends to test the robustness of findings.

### Key Findings (exact phrasing and numerical values preserved)
- Common vs country-specific factors:
  - Evidence that, although common factors explain a large share of inflation variations in the EU, they translate to inflation in individual countries with varying degrees, reflecting the role of country-specific factors.
  - Greater weights of energy and food in Bulgaria’s HICP basket amplifies the impact of shocks on headline inflation.
  - The increase in core inflation in Bulgaria was more pronounced than in the EU.
- GDP deflator decomposition:
  - GDP accounting identity indicates a quick pass-through of supply shocks at the beginning of the inflation surge, followed by an increasing role of the labor market dynamics more recently (similar to the finds of Blanchard and Bernanke (2023) for the US).
- Phillips curve and persistence:
  - Estimation of Phillips curves suggests that second-round effect in Bulgaria might be stronger than in the EU, as indicated by a greater persistence of core inflation and a higher contribution of economic slack.
- Role of policies:
  - Analysis suggests that recent ECB monetary tightening has been insufficient for Bulgaria and its transmission is weak.
  - While fiscal policy in Bulgaria played an important role in supporting the recovery from the COVID-19 pandemic, the analysis finds that it made a non-negligible contribution to inflation as well.

### Organization of the Paper
- The rest of the paper is organized as follows:
  - Section II offers a brief selected review of the literature.

*IMF WORKING PAPERS Inflation Dynamics in Bulgaria: The Role of Policies — INTERNATIONAL MONETARY FUND*

### Section III provides an overview on the recent inflation developments in Bulgaria. Section IV analyzes the

### wpiea2023212-print-pdf - Section III provides an overview on the recent inflation developments in Bulgaria. Section IV analyzes the

### Recent Inflation Developments in Bulgaria
- HICP inflation:
  - soared to 15.6 percent year-on-year (y-o-y) in September 2022.
  - decelerated to 7.5 percent y-o-y in June 2023.
  - Bulgaria’s consumer price increases were the 10th largest in the EU.
- Cross-country divergence:
  - Relative price developments produced growing divergence with best performers in Europe.
- Producer and import price dynamics:
  - Import prices inflation peaked at 22 percent in the second quarter of 2022.
  - Domestic producer price index (PPI) inflation soared to almost 80 percent in September 2022.
- Commodity price drivers:
  - Energy prices inflation reached around 41 percent in the EU and 37.5 percent in Bulgaria in June 2022.
  - Food prices peaked at 22 percent in Bulgaria (November 2022) and almost 17 percent in the EU (March 2023).
  - Contribution of food prices to headline inflation reached 6.4 ppt in Bulgaria and 3.7 ppt in the EU.
  - Energy contribution to headline inflation was similar in Bulgaria and the EU during the peak episode.
- Breadth of inflation:
  - By end-2022, double-digit inflation was recorded in around 65 percent of the HICP commodity groups (at 4-digit level) in Bulgaria, compared to 35 percent in the EU on average.
- Core inflation:
  - Core inflation in Bulgaria was 11.1 percent y-o-y at end-2022 versus 6.2 percent y-o-y in the EU at the same time.
  - Core inflation in Bulgaria rose with lags following headline inflation and has remained elevated despite headline deceleration.

### Contributing Factors — Principal Component Analysis (PCA)
- Co-movement statistics:
  - Average bilateral correlation between q-o-q seasonally adjusted annualized national inflation rates (2007 onward) across EU27 is 0.71.
  - Average bilateral correlation limited to CESEE EU members is 0.76.
  - Correlation for core inflation across the EU is 0.60.
- PCA results:
  - Over two thirds of the variance in inflation in EU member states can be explained by a single principal component.
  - The first principal component explains close to 73 percent of the variance in headline inflation and around 66 percent of the variance in core inflation.
- Country-specific vs common components:
  - Decomposition shows the recent surge in headline and core inflation since 2021 is driven by the single principal component (common shock).
  - The idiosyncratic (country-specific) component for Bulgaria has been negative during the surge period.
  - Bulgaria’s factor loading on the first principal component is relatively high, and for core inflation it is higher than for headline inflation, indicating strong sensitivity to common (global) shocks.
- Cross-country heterogeneity:
  - Factor loadings are generally higher in Baltic countries, Hungary, Czech Republic, and Bulgaria; lower in France, Finland, Malta, and Sweden.
  - Factor loadings in CESEE countries display high correlations with the share of food and energy in consumer baskets (correlations above 0.70 for both headline and core inflation).
  - Factor loadings exhibit an inverse relationship with the size of the economy (-0.38 with headline inflation and -0.47 with core inflation).
  - Trade openness was not a significant correlate of factor loadings in the analysis.

### GDP Deflator Inflation and Phillips Curve Evidence
- Decomposition approach:
  - Using the income side of GDP, changes in the GDP deflator are decomposed into unit profit, unit labor cost, and unit tax contributions.
- Unit profits:
  - Unit profits did not play a large role in changes in the GDP deflator prior to 2021.
  - Unit profits rose in 2021 and the first half of 2022, reflecting pass-through of higher input costs as supply shocks hit the economy.
- Unit labor costs:
  - Contribution of unit labor costs remained muted in 2021 while employment support schemes were in place.
  - Unit labor costs contributed significantly to the increase in the GDP deflator in 2022 as wage increases outpaced productivity growth, particularly in the private sector.
- Labor market and second-round effects:
  - Data suggest gradual labor market tightening and a possible steepening of the inverse relationship between core inflation and unemployment rate during the recent inflation surge, consistent with rising unit labor costs.
- Overall interpretation:
  - Initial inflation surge was largely driven by common external supply-side shocks (commodity and import price shocks).
  - Second-round effects—through profits and wages—contributed to sustaining inflation, with unit profits and later unit labor costs playing notable roles.

*Source: IMF WORKING PAPERS Inflation Dynamics in Bulgaria: The Role of Policies (wpiea2023212-print-pdf).*

### 10. Furthermore, it supports the argument of Gopinath (2022) but from an emerging market economy

### 10. Furthermore, it supports the argument of Gopinath (2022) but from an emerging market economy

### Phillips-curve estimation and inflation persistence
- Sample and specification:
  - Period: 2000Q1–2022Q4.
  - Dependent variable: core HICP (excluding energy, food, alcohol, and tobacco).
  - Regressors: lagged core inflation, one-year ahead inflation expectations (Consensus forecasts), unemployment gap (deviation from HP-filtered unemployment), lagged external price pressure (combined changes in foreign producer price indices and exchange rates), measures of food and energy prices.
  - Estimation: panel regressions for European, Advanced European (AE), and Emerging European (EE) economies; OLS for Bulgaria (BGR). Baseline spans more than 20 years of quarterly data (more than 80 observations).

- Key findings on inflation dynamics:
  - Past core inflation level is a very important driver of current core inflation in Bulgaria; estimated coefficient much larger for Bulgaria than for European, EE, and AE economies, indicating more persistent inflation dynamics.
  - Short-term (one-year ahead) inflation expectation matters for core inflation in Bulgaria; three-year ahead inflation expectation coefficient is much smaller and not statistically significant for Bulgaria.
  - Strong persistence of core inflation suggests inflation expectations in Bulgaria might be largely backward-looking.
  - The steepening of the Phillips curve since mid-2021 suggests shrinking slack played a greater role during the inflation surge.

### Table 2: Selected estimated coefficients (comparative and Bulgaria)
- Unemployment gap:
  - EUR: -0.258***
  - EE: -0.567***
  - AE: -0.106
  - BGR (Column 4): -0.384*
  - BGR (Column 5): -0.377
  - BGR (Column 6): -0.222
- Lag of core HICP inflation:
  - EUR: 0.341***
  - EE: 0.435***
  - AE: 0.238*
  - BGR (Column 4): 0.676***
  - BGR (Column 5): 0.678***
  - BGR (Column 6): 0.826***
- Inflation expectations, 1 year ahead:
  - EUR: 0.607***
  - EE: 0.475***
  - AE: 1.011***
  - BGR (Col 4/5): 0.276*** / 0.268***
- External price pressure (t-1):
  - EUR: 0.028***
  - EE: 0.047***
  - AE: 0.013*
  - BGR: 0.020 / 0.018 (not statistically significant)
- Export share-weighted food price inflation (contemporaneous and lags): several positive coefficients; for BGR contemporaneous food inflation 0.054** and lagged terms mixed (some insignificant), indicating food prices are statistically significant and signal second-round effects.
- Export share-weighted energy price inflation: positive and statistically significant in panel estimates; not statistically significant for BGR in the reported columns.
- Inflation expectations, 3 years ahead (BGR): 0.095 (not statistically significant).
- Observations and fit:
  - EUR panel observations: 2,552; R-squared: 0.734; country FE: Yes.
  - EE panel observations: 530; R-squared: 0.832; country FE: Yes.
  - AE panel observations: 2,022; R-squared: 0.479; country FE: Yes.
  - BGR OLS observations: 88 (Cols 4–5) and 62 (Col 6); R-squared: 0.855, 0.857, 0.825 respectively; country FE and time FE: No.
- Statistical notation preserved: Robust standard errors in parentheses. Significance: *** p<0.01, ** p<0.05, * p<0.1.

### Interpretation and robustness
- Estimation extensions and robustness checks (Annex I) confirm persistence of inflation dynamics.
- Sensitivity analyses include: controlling for time and fixed effects in panel estimation; allowing cross-dummies with unemployment gap for 2007Q1–2008Q2 and post-2021Q2; restricting sum of coefficients on past and expected inflation to 1; alternative unemployment-gap measure — findings are similar.
- Result for unemployment gap is robust when an HP-filter based output gap is used instead of the unemployment gap.
- Medium-term (three-year) inflation expectations are stable around 2.5 percent in recent inflation surges, which aligns with the smaller role of medium-term expectations for Bulgaria.

### Role of policies — Monetary policy
- Institutional constraint:
  - Bulgaria operates a long-running currency board with the euro; the BNB does not set a policy interest rate under the currency board.
  - ECB monetary policy directly influences monetary conditions in Bulgaria via deposit and interest rates, external demand, effective exchange rate vis-à-vis non-euro area countries, import prices, and capital flows.
- Taylor-rule assessment:
  - A Taylor-rule implied policy interest rate for Bulgaria is derived using average parameters from a range of existing euro-area studies and Bulgaria’s output gap (HP filter on seasonally-adjusted quarterly GDP for 2000Q1–2022Q4).
  - The difference between the actual ECB deposit rate and the Taylor rule-based interest rate indicates ECB’s policy was too accommodative for Bulgaria in 2021–22 and remains so as of mid-2023 (Figure 12).
  - Caveat: Taylor rule parameters apply to euro area; neutral rate for Bulgaria likely higher, so estimated Taylor rule-based rate may be lower than appropriate for Bulgaria.
- Transmission issues:
  - External bank funding costs have risen (3-Month EURIBOR increased in line with ECB policy rates since July 2022).
  - Interest rates on retail deposits in Bulgaria remained low despite ECB policy rate increases, reflecting abundant banking-sector liquidity (bank-held private deposits-to-loans to the private sector shown in Figure 14).
  - Interest rates on new loans to nonfinancial corporations in Bulgaria have increased less than in the euro area; interest rate on new mortgage loans to households in Bulgaria has hardly increased while euro-area mortgage rates have jumped (Figures 15–16).
  - Low funding costs and strong competition for credit market share have underpinned slow transmission of ECB tightening.
- BNB tools within the currency board:
  - Minimum required reserves (MRR) rate: BNB sets MRR; higher unremunerated MRR increases banks’ funding costs and is expected to exert upward pressure on lending rates.
  - In June and July 2023, BNB increased MRR from 5 percent (liabilities to nonresidents) and 10 percent (residents) to 12 percent (for both) in two steps.
  - Interest on excess reserves: remunerating excess reserves could encourage banks to hold liquidity at the BNB, but BNB historically did not remunerate excess reserves due to potential cost increases.

### Role of policies — Fiscal policy and structural VAR analysis
- Observation:
  - Cross-country simple observation: EU countries with large cyclically-adjusted primary deficits in 2021 are associated with higher core inflation in 2022 (Figure 17). Bulgaria is highlighted in the scatter.
  - Caveats: CAPB is unobserved and estimates may include non-policy-related movements; identification via structural methods preferred.
- VAR setup and identification:
  - VAR variables: real GDP growth (log difference), core inflation (excluding energy and unprocessed food), short-term interest rate, primary fiscal balance in percent of GDP in the previous quarter.
  - Sample: 2004Q1–2022Q4; baseline model uses four lags; primary balance is moving-averaged over four quarters.
  - Fiscal shock identification: sign restrictions such that a tightening fiscal policy raises primary balance but lowers GDP growth or inflation (contemporaneous sign restrictions only).
  - Additional identified shocks: aggregate demand shock (lowers GDP growth and inflation, reduces primary balance via automatic stabilizers) and aggregate supply shock (different signs on GDP growth and inflation). Aggregate demand and supply shocks can comprise global and domestic components.
- Impulse-response result (summary as provided):
  - A one-standard-deviation unexpected expansionary fiscal shock reduces the primary balance by 0.45 percent of GDP while increasing annual output growth (figure references and credible intervals reported in Figure 18).

*Source: wpiea2023212-print-pdf*

### 0.5 percent, implying a fiscal multiplier of 1, which is in

### Inflation Dynamics in Bulgaria: The Role of Policies

### Fiscal shock effects and fiscal multiplier
- A simulated fiscal expansion raises output by 0.5 percent, implying a fiscal multiplier of 1.
- Annual inflation increases by 0.2 percentage points following the fiscal shock, with effects fading only gradually consistent with the persistence of core inflation identified in the Phillips curve estimation.
- Forecast error variance decomposition: fiscal policy shocks explain about 15–25 percent of inflation variation on average, with larger explanatory power in the short term.

### Historical contributions of fiscal policy to growth and inflation (COVID-19 period)
- 2020: model attributes the significant drop in output growth mainly to non-fiscal shocks (aggregate demand and supply); the negative contribution of fiscal policy suggests fiscal support in 2020 was relatively smaller than the severity of the shock.
- 2021: fiscal support (beyond endogenous response) is estimated to have contributed 2.8 percentage points to output growth, almost 40 percent of total output growth.
- 2022: fiscal policy added about 1 percentage point of output growth (total effect including lagged effects).
- Inflation contributions:
  - Fiscal shocks explain about 1.2 percentage points of inflation in 2021.
  - Fiscal shocks explain about 3 percentage points of inflation in 2022.
- Mechanism: impact of fiscal policy on output growth fades quickly, while its impact on inflation is persistent; lagged fiscal supports implemented at end-2021 produced significant positive inflation effects in 2022.

### Role of non-fiscal shocks and external factors
- Non-fiscal shocks (particularly aggregate demand and supply) are the main contributors to inflation in Bulgaria once deterministic contributions and initial conditions are excluded.
- In 2021, negative contribution to inflation partly reflects persistent negative demand shock from 2020 and supply-side improvement in 2021.
- In 2022, non-fiscal shocks explain, on average, more than 40 percent of core inflation; external factors cited include supply-chain constraints and the energy crisis amid post-pandemic demand recovery.
- The pre-determined factor (sample-dependent) being greater than 2 percent partly reflects the on-going convergence path of inflation in Bulgaria.

### Sensitivity analyses and robustness checks
- Alternative fiscal indicators examined: primary balance excluding grants, cyclically-adjusted primary balance excluding grants, overall balance in cash, overall balance in accrual. Results are similar; the contribution of fiscal policy to inflation is slightly larger when using the overall balance in accrual.
- Alternative interest rate measures considered: interbank money market overnight rate (baseline), short-term interest rate (OECD), rate of less-than-one-year deposits, and government bond yield for newly issued bonds with maturity over a year. Results corroborate fiscal contribution to inflation, particularly in 2022.
- Pre-COVID sample (2004Q1–2019Q4) yields similar results, indicating stability of model parameters.

### Extended model controlling for Euro Area (EA) monetary policy
- Extended VAR adds a measure of EA monetary policy stance: the interest rate gap between actual ECB interest rate and a Taylor-rule based rate.
- Identification: sign restriction where a positive EA monetary policy shock increases the ECB Taylor gap, puts upward pressure on Bulgaria’s short rate, and lowers inflation and output growth contemporaneously; contemporaneous impact on Bulgaria short-term rate assumed larger in absolute terms than impact on inflation and output growth (reflecting currency board and quicker financial transmission).
- In the extended model:
  - Fiscal policy contribution to inflation in 2022 remains robust but slightly smaller at 2.5 percentage points.
  - Too-loose ECB monetary policy stance contributed about 1 percentage point to inflation in Bulgaria in 2022.

### Model, estimation, and identification details
- VAR specification: four endogenous variables — real GDP growth (log difference of real GDP), core inflation (excluding energy and unprocessed food), a measure of short-term interest rate, and the primary fiscal balance in percent of GDP.
- Structural form: A0 Xt = B0 + sum_{l=1}^q Bl X_{t−l} + εt, with εt orthogonal structural shocks (Gaussian mean zero, identity covariance).
- Reduced-form representation and Gibbs sampling: 40,000 draws with first 32,000 used for burning; Normal-Wishart prior applied.
- Fiscal shocks identified using sign restrictions.

### Phillips curve and inflation persistence
- Phillips curve estimation indicates greater persistence of core inflation in Bulgaria than in the EU and an increasing role of economic slack in recent inflation.
- Selected estimated coefficients (BGR OLS specifications summarized in Annex I):
  - Unemployment gap: coefficients reported including -0.368, -0.391, -0.379*, -0.283*** across alternative specifications.
  - Lag of core HICP inflation: 0.676***, 0.675***, 0.677***, 0.620*** in various BGR specifications.
  - Inflation expectations, 1 year ahead: 0.267***, 0.277***, 0.323***, 0.192** in various BGR specifications.
  - Export share-weighted food price inflation contemporaneous coefficient examples: 0.054*, 0.054*, 0.053*, 0.017.
- R-squared for BGR columns reported around 0.857, 0.855, 0.872 in specified regressions.

### Policy implications and conclusions
- External factors (supply-chain constraints, commodity and food price shocks, synchronized policy supports) played an important role in Bulgaria’s inflation dynamics; country-specific factors (larger weight of energy and food in CPI) amplify headline inflation.
- Second-round effects appear stronger in Bulgaria due to greater core inflation persistence and an increasing role of economic slack.
- ECB monetary tightening appears to have been insufficient for taming inflation in Bulgaria, aggravated by weak monetary transmission given significant liquidity and strong competition in the banking sector under the currency board.
- Fiscal policy, while supporting rapid recovery, likely contributed to the inflation surge; this underscores the importance of fiscal policy discipline and liquidity management in managing inflation risks in Bulgaria given the currency board arrangement.
- Suggested avenues for future research include: using narrative approaches to identify fiscal shocks, studying nonlinearity in policy-inflation relations across business-cycle phases, and quantifying differential effects of various types of ECB monetary shocks (short-term rate changes, forward guidance, quantitative easing) on Bulgaria’s inflation dynamics.

*Source: IMF Working Paper No. WP/2023/212*

---


_Source: https://www.imf.org/-/media/files/publications/wp/2023/english/wpiea2023212-print-pdf.pdf_