6. Soaring inflation poses new policy trade offs

Inflation has risen to record highs globally on the back of rebounding demand, supply constraints, and surging commodity prices, particularly, since the outbreak of the war in Ukraine in February 2022. In July 2022, the global median headline Consumer Price Index (CPI) rose to 9.4 percent y-o-y, the highest level since 2008 (Figure 6.1).22 Several factors are behind the increase in inflation. Rising energy costs are contributing significantly to mounting inflationary pressures (Figure 6.2). The cutoff of natural gas to several European countries, including the shut-down of the Nord Stream pipeline, has pushed the gas prices to record highs. In September 2022, Brent crude oil stood at US$90.2 per barrel, more than 20 percent increase over a year. Global food prices suffered sharp increases through June 2022, though they have been on a declining trend since, due to, among other factors, the resumption of exports from ports in the Black Sea in Ukraine. However, food prices in August

2022 were still 11 percent higher than last year,23 disproportionally affecting disposable incomes of the poor, given that food items account for a higher share of their consumption basket. Food price increases have been partially made worse by the growing number of food trade restrictions put in place by many countries. As of September 2022, at least 20 countries have implemented 29 food export bans, and at least seven have implemented 12 export-limiting measures.24

While commodity prices continue driving up headline inflation numbers, price pressures are increasingly broad-based (Figure 6.3). Increases in prices were particularly pronounced for commodities of which Russia and Ukraine are large exporters, such as natural gas, fertilizers, grains and metals. Moreover, pandemic-related effects linked to shortages of materials, equipment and workers also continue to impact price increases. While food and energy prices have mainly driven the sharp rise in headline inflation, core inflation has also risen globally (Figure 6.4).

The degree of inflation persistence is uncertain and the risk of higher inflation becoming further entrenched in expectations is significant. Mounting inflation prompted central banks across the world to step-up policy interventions, withdrawing monetary support and raising interest rates faster to ease inflation pressures. In many emerging markets and developing economies that have adopted inflation targeting, inflation increased above target. As a result, central bank monetary policy tightening is taking place more rapidly than anticipated at the start of the year and faster than in advanced economies. In the short term, expectations of further price increases could become entrenched into price-setting behavior, resulting in the greater persistence of inflation. At the same time, raising interest rates and tighter financing conditions could weigh on economic activity.

Monetary authorities are facing a few tradeoffs in calibrating their monetary policy stance. Despite stagnant economic growth, mounting price pressures encourage central banks to tighten their policy stance to reduce inflation expectations. At the same time, tighter monetary policy will inevitably have consequences for the economy, including those associated with the negative impact on bank’s balance sheets and on debt financing for businesses and households. Countries without independent monetary policy have limited room to mitigate the impact of rising inflation, exacerbated by the war in Ukraine. In such contexts, supply-side policies aimed at boosting competitiveness and enhancing productivity, and reducing energy dependence are critical.

Between January and July 2022, inflation in the Western Balkans soared in all countries in the region (Figure 6.5). A combination of supply- and demand-side factors played a role in driving up price pressures. On the one hand, supply constraints drove food and energy prices to record highs and they were amplified by the war in Ukraine (Figure 6.6); on the other, lingering demand-supply imbalances from the COVID-19 recovery continue to weigh on prices at the regional level. In July, annual headline inflation reached 7.5 percent in Albania and up to 16.7 percent in Bosnia and Herzegovina. Energy tariff controls and a mild currency appreciation prevented a similar pickup of inflation in Albania. Food and energy inflation continue to represent key components of the overall increases. The Consumer Price Index (CPI) for food rose above 24 percent in Bosnia and Herzegovina, Montenegro, and North Macedonia. Energy CPI trends were also on the rise, with growth reaching 15.7 percent in Montenegro to 18.1 percent in Bosnia and Herzegovina. Finally, since January 2022 core inflation increased in almost all countries in the region (Figure 6.7). Higher increases were observed in Montenegro, Serbia, and Albania where in July 2022 core inflation reached 9.4 percent, 7.5 percent, and 7.3 percent, respectively.

In countries with flexible or managed exchange rate regimes, central banks responded by tightening monetary policy, in line with the Eurozone. In Serbia, the central bank increased its key policy rate several times, reaching 3.5 percent at the end of the third quarter. The increase in inflation expectations (Figure 6.8) also prompted a faster monetary policy normalization in Albania, where the central bank raised its key policy rate to 1.75 percent in August 2022 (Figure 6.9). In North Macedonia, the policy rate was increased to 3 percent in five rounds by early September. Exchange rate pressures differed among the Western Balkan countries; while in North Macedonia the central bank intervened to keep the stability of the exchange rate, decreasing foreign exchange reserves by 20 percent, in Albania currency appreciation vis-à-vis the euro prevented a more rapid pass through from imported inflation. In Serbia, the nominal dinar exchange rate was stable throughout 2022 (Figure 6.10).