The exterior of the National Bank of Poland
The question for the region’s central banks is how high and fast to raise interest rates without harming the post-pandemic economic recovery that was taking shape before February © Wojciech Strozyk/Alamy

War, political tensions and a deteriorating macroeconomic outlook are testing the skills of central banks in Hungary, Poland and Romania. They add up to the region’s third great challenge after the 2008 financial crisis and the transition from communism to a market economy in the 1990s.

Month by month, the central banks are raising interest rates to curb inflation pressures that were already rising before Russia’s invasion of Ukraine in February drove up the prices of oil, gas, metals, food and fertilisers. Yet real interest rates remain deep in negative territory, a sign that more hikes will be needed to reduce or anchor inflation expectations.

For the central banks, the question is how high and fast to raise rates without harming the post-pandemic economic recovery that was taking shape before February. Unfortunately, some factors that might ease their task lie beyond their control.

Hungary, Poland and Romania hope to maintain economic growth with the help of tens of billions of euros from the EU’s €800bn post-Covid recovery fund. But disputes over the rule of law with Brussels mean that Hungary and Poland have yet to receive a cent from the fund, whilst doubts persist about Romania’s ability to absorb EU money efficiently.

The region’s central banks need to manage inflation without excessively pushing up debt-servicing costs, Jakob Suwalski and Levon Kameryan of Scope Ratings wrote last week. “Inflation expectations are rising. Currency volatility will persist amid possible capital outflows, putting pressure on foreign exchange reserves even as central banks tighten monetary policy.”

Hungary is a case in point. Its central bank raised its base rate by 100 basis points last month to 4.4 per cent, but annual inflation is currently 8.5 per cent. The central bank estimates average inflation this year will be 7.5 per cent to 9.8 per cent.

More rate increases are clearly on the way. Peter Virovacz of ING bank sees a chance for a positive real interest rate by the end of this year, which would probably mean 8 per cent or higher. But Hungary’s central bank is not operating in a policy vacuum.

Before this month’s parliamentary elections, Hungary’s government wooed voters with lavish social benefit payments, wage settlements and tax cuts. These measures increased Hungary’s budget deficit, which came under more pressure from expenditures related to the Ukraine war.

The forint fell in early March to a record low of 400 to the euro. It has stabilised since then, but to reassure investors the government must bring public expenditure under control. Yet spending cuts and sharply higher interest rates, coupled with lack of access to the EU recovery fund, would put the Hungarian economy under considerable strain.

Annual Polish inflation hit 11 per cent last month and is expected to average about the same for the whole year. On April 6, its central bank raised its benchmark interest rate by 100 basis points to 4.5 per cent. Adam Antoniak of ING foresees the rate rising to 6.5 per cent this year and 7.5 per cent in 2023.

Interest rates may therefore remain negative this year, even as pressure mounts on the fiscal side. The war in Ukraine is generating increased spending on defence and education as well as healthcare and social protection for the more than 2.5mn refugees who had arrived in Poland by early April.

Furthermore, the government plans to cut the personal income tax rate to 12 per cent from 17 per cent and introduce other tax benefits. Such measures make the task of managing inflation expectations especially urgent. Adam Glapinski, the central bank governor, rightly points to the Polish economy’s strong fundamentals. To protect them, he may raise rates more aggressively than some investors anticipate.

Annual Romanian inflation rose to 10.2 per cent in March, but the main interest rate is only 3 per cent despite a 0.5 percentage point increase in early April. Economists expect average inflation this year of around 9 per cent.

For the National Bank of Romania, the difficulty is that higher rates seem necessary but economic growth is fading. “A ‘do the least and hope it holds’ strategy seems to have been the tool of choice so far and we have little reason to expect any change in the policy stance,” says Valentin Tataru of ING.

Central and eastern Europe’s economies are vulnerable to the fallout from the Ukraine war. To defend them, the region needs central banks willing to tame inflation — but also governments willing to take tough decisions on spending and relations with the EU.

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