Disinflation in EU Countries outside the Eurozone

IMF Blog, February 2, 2015

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Authors: Plamen Iossifov, Jiri Podpiera
Published: February 2, 2015

Overview and context

Authors: Plamen Iossifov, Jiri Podpiera
Date: February 2, 2015
Key observation: Inflation has been falling sharply across Europe since 2012.
Affected groups:
- Countries pegging currencies to the euro: Bulgaria, Croatia, Lithuania (adopted the euro on January 1, 2015).
- Inflation targeters experiencing declines: Czech Republic, Hungary, Poland, Romania.
Related IMF commentary: Risks from low inflation in the euro area discussed in the March 2014 iMFdirect post.

Drivers of disinflationary dynamics

Primary drivers:
- Falling world food and energy prices.
- Cuts in administered prices of energy where relevant.
Core inflation trends:
- Core inflation (excluding food and energy) has drifted down, tracing euro area price trends and diverging from the rest of the world.
- Suggests disinflationary spillovers from the euro area via close trade links.
Findings from IMF Working Paper (Iossifov and Podpiera, 2014):
- Falling world food and energy prices and related cuts in administered prices account for the largest share of the inflation decline in non-euro area EU countries in Central and Eastern Europe.
- Falling euro area core inflation spills over through lower prices of imports to countries with currencies pegged to the euro and, to a smaller extent, to inflation targeters with higher foreign value-added content in domestic demand.
- The domestic economic cycle (measured by the unemployment gap) has had a marginal impact in the recent disinflationary episode.
- The nominal effective exchange rate has been proportionately more important in inflation targeters.

Short-term benefits vs. medium-term risks

Short-run gains from lower oil and energy prices:
- Lower energy prices boost purchasing power of households and businesses.
- With still negative output gaps throughout the region, a pick-up in demand would benefit domestic producers.
- Lower outlays ease liquidity strains of debt service for heavily indebted firms and households, reducing default risk and related negative effects on consumption and investment.
Medium-term costs and risks:
- Risk of “second-round” disinflationary effects that can be difficult to reverse, increasing debt sustainability risks.
- Falling prices could suppress domestic demand if households and firms revise down wage and profit expectations and cut consumption and investment, potentially triggering a self-feeding deflationary trap.
- Persistent disinflation/deflation can complicate deleveraging by increasing the real debt burden, exacerbated if stagnating nominal incomes are not offset by lower nominal interest rates passing through to debt servicing costs.

Near-term outlook and projections

With rapidly falling world oil prices, disinflation pressures are unlikely to abate soon.
According to the latest WEO forecasts and IMF estimates:
- Headline inflation is expected to stay low through 2015 in euro peggers.
- Headline inflation is expected to remain below targets in Hungary, Poland, and Sweden.
The sharp decline in oil prices since June 2014 will continue to drag inflation lower as the commodity price drop filters through to domestic prices.

Policy implications and options

Constraints and considerations:
- Countries pegged to the euro lack independent monetary policy and must rely on the ECB’s quantitative easing (QE) response to persistently low euro-area inflation.
- Where fiscal space allows, fiscal policy can be used to stimulate demand.
- Inflation-targeting central banks should aim to bring inflation closer to target and prevent “second-round” disinflationary effects.
- Policy instruments are at historical lows or at the zero lower bound, complicating further easing.
- Further monetary easing must weigh benefits of normalizing price pressures against risks to financial stability and capital flows (and hence exchange rates).
- Easing too much may prompt capital outflows; while outflows can help depreciate exchange rates and raise inflation, there is a risk the process may go too far—especially for countries with high shares of debt in foreign currencies.
- These countries are more exposed to changing investor risk appetite, geopolitical concerns, and global financing conditions.
- The recently announced QE by the ECB opens additional space for monetary easing by inflation-targeting central banks outside the eurozone.
Overall policy assessment:
- The greater concern at present appears to be very low inflation and the possibility of sliding into a deflationary trap rather than financial instability from capital outflows.
- Policymakers need to keep a watchful eye on markets while focusing on preventing second-round disinflationary effects.

Source: Disinflation in EU Countries outside the Eurozone — Plamen Iossifov, Jiri Podpiera (February 2, 2015).

Disinflation in EU Countries outside the Eurozone

Source details

Other formats

Bibliographic details

Overview and context

Drivers of disinflationary dynamics

Short-term benefits vs. medium-term risks

Near-term outlook and projections

Policy implications and options

References