Deflation danger rings wake-up call to east Europe central banks

[LONDON] Central banks across the European Union's eastern countries are overcoming their aversion to chasing deflation with monetary easing, and investors are betting that the new rate-cut cycles are just getting under way.

Poland, where prices have been falling since July, ended a five-month pause with an interest-rate cut this month. Hungary on March 24 lowered its benchmark after a seven-month interlude, following deflation in nine of the last 11 months. Czech policy makers are weighing whether to weaken the koruna and Romania's central bank is forecast to cut rates on Tuesday.

With economies plugged into the euro-region, their main export market and source of funding, eastern EU nations are struggling to control downward pressure on prices. The European Central Bank's 1.1 trillion-euro (S$1.64 trillion) bond-buying plan is complicating the task by strengthening the currencies of the euro area's neighbors, which offer higher rates.

"Every month, it's just another wake-up call for the central banks to cut interest rates," Simon Quijano-Evans, the London-based head of emerging-market research at Commerzbank AG, said by phone. "If you have a spread in your central bank rate versus the ECB, you're going to see inflows, you're going to import disinflation, deflation and there's very little you as a central bank can do other than cut rates." Traders are wagering more interest-rate cuts both in Poland and Hungary. Forward-rate agreements predicting Polish borrowing costs in six months in Poland are trading 15 basis points below the Warsaw Interbank Offered Rate. The spread between Hungarian six-month FRAs and the Budapest Interbank Offered Rate is 33 basis points.

The Romanian central bank will cut its key rate by a quarter point to a record 2 per cent, according to six of seven economists in a Bloomberg survey.

In Poland, the central bank's vow to keep rates unchanged after a half-point cut to 1.50 per cent on March 4 hinges on the zloty's ability to avoid strengthening as the country attracts capital, central bank Governor Marek Belka said in an interview this month, adding that thus far he hadn't seen any reason for concern in that regard.

The Polish currency advanced to 4.0708 per euro on March 26, its strongest since January 2013, tracking bond gains.

"The market has started to ride the ECB QE wave with vigor," Gabor Ambrus, an economist at Royal Bank of Scotland Plc in London, said by e-mail. "Rate cuts are here to stay, and they can get much deeper than generally anticipated."

The forint is getting a boost after the National Bank of Hungary cut its main interest rate to 1.95 per cent from 2.10 per cent, a smaller reduction than the 20 basis points predicted by most analysts in Bloomberg survey. The currency has kept appreciating even as Governor Gyorgy Matolcsy said "cautious" easing may continue.

"An extension of the favorable forint momentum may embolden the NBH," Cristian Maggio, head of emerging-market strategy at TD Securities in London, said in an e-mailed note.

Central bankers are navigating an uncharted territory, where accelerating economic growth is accompanied by low inflation.

With the economy growing at more than 3 per cent pace in the last five quarters, Poland's central bank hesitated on reducing borrowing costs further until March, even as Poland is grappling with its longest bout of negative price growth.

Policy makers in Hungary had planned to keep borrowing costs steady throughout 2015 until the persistence of declining consumer prices swayed them. Even as March government releases showed retail sales jumped the most in almost 11 years and industrial-output growth was double the pace predicted by economists, they abandoned that stance last week.

Hungarian rate setters lowered their forecast for 2015 inflation to zero after prices fell the most since the 1960s, while lifting their estimate for economic expansion to 3.2 per cent from 2.3 per cent. Poland's Finance Ministry is starting work on next year's budget with the assumption that gross domestic product may advance faster than its current forecast of 3.4 per cent in 2015.

From the perspective of growth, "central banks would be comfortable to refrain from further rate cuts," Marcin Adamczyk, who helps manage US$7 billion in emerging-market debt at ING Investment Management in The Hague, said by e-mail. "It's more the fear of additional deflationary pressure created by strengthening currencies than the export competitiveness worries" driving policy.

Even so, the room for easing is limited as the US Federal Reserve prepares to raise rates, according to Peter Schottmueller, who helps manage US$17 billion as head of emerging- market fixed income at Deka Investment GmbH in Frankfurt.

Fed officials on March 18 signaled they needed to be convinced inflation would eventually accelerate before lifting borrowing costs. As the exit from the most aggressive easing in the Fed's 100-year history draws closer, riskier emerging-market assets will become less attractive.

The Fed's "tame behavior" provided some "bullishness" to emerging markets, "but as soon as we approach the second half, nervousness will return," Mr Schottmueller said by e-mail. "Central banks are aware of that; therefore, they may not cut rates as low as they could." Easing is being considered even in the Czech Republic, where interest rates are at what the central bank calls a "technical zero" and there's been a limit to currency gains in place as an instrument to combat deflation since November 2013.

Policy makers on March 26 left the key rate unchanged for a 19th meeting and left a limit to the koruna's gains at 27 per euro. Recent currency strength prompted the panel to warn that they may move the cap, meant to be in place until at least July 2016, to a weaker level.

"Due to low commodity prices, which could push inflation into negative territory for an extended period of time and reflect adversely on domestic demand, we do not exclude further easing" Marsa Bobanovic, London-based analyst at RBS wrote in an e-mailed note, adding that "we don't exclude negative interest rates."

BLOOMBERG