Inflation: Through the (Taylor) Looking-Glass
In this report, we would like to look beyond the façade of inflation via the lens of the augmented Taylor rule in order to see what kind of implications it may have for monetary policy across CEE.
The development of inflation over the past few months has astounded pretty much everyone. In many CEE countries, inflation has topped the upper limit of the inflation target. It may peak in the last quarter of this year and early 2022, before embarking on a declining trajectory from 2Q22 onwards, aided by the base effect. Yet, because we expect it to remain elevated in several large CEE economies in early 2022, average inflation rate in CEE8 may rise by 0.7pp from 4.4% this year to 5.1% in 2022 (projected above the target for the entire year in many countries) before easing more visibly in 2023.
One way to look at what this year’s development of inflation may imply for monetary policy is via the Taylor Rule. Although it does not account for all possible factors that may be relevant in terms of monetary policy setting, it is a useful fixed rule policy aid. We augment the original Taylor Rule to look at the deviation of unemployment rates from non-accelerating wage rates of unemployment (so called NAWRUs) estimated by the European Commission. We relate it closer to the real economy slack via Okun’s factor and also use our estimated regional natural real interest rates in the Taylor equation.
The results from our adjusted Taylor Rule point convincingly to the need for tighter monetary policy across the region. Based on the last completed quarter (3Q21) and using headline CPI inflation as the key input for consumer price increases, nominal interest rates should have been close to 2.75-3.2% in Czechia, Slovenia and Poland, and 1.9-2.3% in Hungary, Croatia and Slovakia. Due to the high inflation, Romanian Taylor-Rule-implied rate would shoot up to 5.2%.
However, the picture changes when we consider core inflation as the key inflation input. Overall, the suggested nominal rates are much lower – ranging from 0.06% in Croatia to around 1.5% in Czechia and Slovakia. This seems to underline the lower intensity of domestic inflationary factors compared to the headline figures which are affected by external factors, too. Nonetheless, tightening would seem appropriate in some CEE economies even when taking into account core inflation as key for the Taylor Rule.
Many CEE countries have already embarked on a monetary tightening path – this was most prominently seen in Czechia, Hungary, Poland and Romania. In fact, all regional central banks except for the Croatian and Serbian ones began to tighten monetary policy amid surging inflation and worries about second-round effects. Whereas the key ECB rate is at zero, the current inflationary development in Slovakia and Slovenia would call for rate hikes if possible.