What Common Factors are Driving Inflation in CEE Countries?

The aim of the research is to find common driving forces in the inflation development across 10 emerging economies from the Central and Eastern Europe (CEE). As opposite to the previous research on this subject we are going to differentiate not only between regional and country specific common factors. We also believe that there are some common price movements across the particular sectors in the CEE countries. The common trends may stem from the fact that all the countries in the region have undergone the period of structural (market) reforms, foreign trade liberalization (especially with EU countries), productivity improvements and hyperinflation on the unprecedented scale. Afterwards, a common source of price determination across the region was the economic stabilization towards meeting Economic and Monetary Union (EMU) criteria of nominal and fiscal convergence. In the last decades we also observe a growing synchronization of the business cycle among these economies. We decompose product-level HICP indices into common aggregate (regional in terms of CEE countries), country, and sector specific components to study the co-movements in inflation rates across group of CEE countries in a systematic manner. To this end we apply a hierarchical factor model with an overlapping country-sector structure and estimate it with an iterative method of Beck, Hubrich and Marcellino (2011). Our findings are also closely related to the hypotheses on differences in the degree of volatility and persistence at the aggregate and disaggregate level (Bils and Klenov, 2004, Klenow and Kryvtsov, 2008, Boivin, Giannoni, and Mihov, 2009, Mackowiak and Wiederholt, 2009). The research finds a considerable degree of price co-movements across countries and sec-tors. The more open economies the more vulnerable they are to external shocks coming from changes in commodity prices, exchange rates and other parts of financial global market. We find that all common factors explain about 36.5% of variance in product-level monthly price changes. Among them the most important are two aggregate (regional) factors that contribute to about half of the total variance explained (17%), less important are country (6.5%) and sector-specific (3%) components. The contribution of CEE regional component varies considerably between different countries and sectors. It is the most prominent determinant of inflation in Romania (explaining 55% of price variability), and the least important for Estonia (10%), the Czech Republic (8%) and Slovenia (6%). For the other countries the fraction of explained variance is between 13% (Poland) and 18% (Bul-garia). The regional CEE component explains from 11% of variance in food and non-durable sector to 24% in services on average being the most important price determinant in each of them. The first regional common factor may be associated with the disinflationary process explaining lowering of the inflation expectations that occurred in CEE countries, whereas the second regional factor reveals correlations with the global factors, especially commodity prices and euro area price development. As the sector specific factors are concerned, according to the expectations, prices of food and other non-durable goods (which mostly consist of energy goods) strongly depend on the commodity markets. Prices of services revel the highest correlation with the unemployment in the analyzed countries mirroring the impact of the business cycles on the prices in services. , though it is not a strong one. Surprisingly there is hardly no influence of the changes in the global or domestic economic activity on the prices of durable and semi-durable goods. Probably it is due to the fact, these prices of these components are influenced by the globalization process, which leads to the price decreases regardless the phase of the business cycle.