Prices will continue to rise, a potential slowdown could come from stagnation in interest rate declines

Annual growth rates are somewhat slowing post-pandemic (to 3.1 percent in 2023), but this remains among the highest rates in the euro area, which we can primarily thank for the surge in domestic demand. This, as IMF representatives recently concluded during their visit, is occurring in conditions where the labor market is strongly growing and Croatian government policies support household income, while EU fund resources stimulate investments. Inflation has significantly decreased since the beginning of 2023, but it is still higher than the average in the euro area, with persistent and elevated inflation in service prices. Therefore, Croatia’s short-term economic outlook is favorable, but they warn that weak productivity and a labor shortage are challenges for its medium-term growth prospects.

However, as long as we are flying on the wings of demand and rising prices primarily of services that abundantly fill the budget, few will be concerned. Therefore, it is good to know why service prices are skyrocketing, until when this will last, and whether we can prevent the consequences.

RBA analysts say that we are not entirely alone in this trend; moreover, across Europe, recovery and subsequent growth in economic activity are predominantly reliant on the service sector.

– In conditions of persistent and strong demand for services following the normalization of supply chains, the spillover of higher input costs, such as fuel for motor vehicles, furniture, and electricity, onto end consumers, coupled with strong household income growth, greatly supports further demand for services, enabling the continuation of price growth. Service inflation, compared to other components of the consumer price index, is more sensitive to wage increases and the subsequent rise in demand. Geographically, the problem of service inflation is widespread, but there are differences from country to country. For example, in Croatia, there is a particularly noticeable increase in restaurant and hotel prices, influenced by foreign demand, especially in the central part of the tourist season. This has been affected, for instance, by the recovery after the pandemic and the subsequent proximity of emitting markets, entry into the Schengen area, the perception of Croatia as a safe destination, improvement in the quantity and quality of offerings, and certainly the convergence of prices towards the EU average. In the euro area, the persistence of prices has also been somewhat influenced by the earlier Easter this year, volatility in air ticket prices, tourist arrangements, or rising insurance prices, which is also related to previous increases in the prices of certain goods (for example, cars). Statistical effects should not be overlooked, i.e., the effects of base periods such as the subsidization of public transport in Germany last year, which sometimes pushed the annual growth rate to higher levels this year – they explain at RBA.

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Marijana Ivanov

photo Ratko Mavar

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Marijana Ivanov from the Faculty of Economics in Zagreb reads the past financial crisis from trends, which was pushed in Mediterranean countries precisely by the rise in service and real estate prices.

– An abundance of money allows for price increases that are higher than in other countries and has adverse consequences for export competitiveness, primarily of goods exports. The nominal exchange rate of the kuna to the euro is irreversibly fixed, but that does not mean we cannot record a decline in competitiveness in terms of the real exchange rate if our inflation is higher than elsewhere, or a decline in competitiveness in terms of the real effective exchange rate, which is actually the key indicator of a country’s competitiveness and the indicator that best shows why the economies of Greece, Italy, and some other eurozone members collapsed after adopting the euro. The problem was not just excessive public debt and deficits; they were actually a consequence of all other problems and declining competitiveness that were attempted to be limited by excessive fiscal spending – Ivanov specifies, adding that the trap for Croatia is that after the introduction of the euro, the exchange rate falls out of the public focus, and people suffer from monetary illusion and think in nominal rather than real terms, believing that a fixed nominal exchange rate also means a fixed real exchange rate.

– This, of course, is not true, as it changes in terms of the real effective exchange rate for each individual country and member of the euro area, taking into account differences in inflation that it records compared to inflation in its most important trading partners. This is calculated using several different deflators – consumer price index, producer price index, unit labor costs for the total economy, and unit labor costs for the manufacturing industry. According to the latter, Croatia recorded the largest decline in competitiveness before and after the global financial crisis of 2008, and due to the abundance of money, it is now at risk of repeating that scenario. A decline in competitiveness and exports means greater pressure on fiscal expenditures and a path to rising budget deficits, but since goods exports do not bring revenue to the budget (as there is no VAT), politicians usually do not pay attention to the competitiveness problem of goods exports, and in a tourist country like Croatia, fiscal revenues are also filled by foreign tourists through their spending, so it is clear that tourism and prices are perfect as they are – Ivanov concludes.

Demand inflation

RBA adds that despite the fact that unusually high current pressures are still noticeable in monthly changes in the first part of the year in a special aggregate of the consumer price index (monthly growth above long-term averages), there is still a noticeable gradual easing of price growth compared to the same periods a year or two earlier. The same, they say, applies to the euro area as a whole.

– It is worth mentioning that, unlike cost inflation caused by disruptions in global supply chains and the energy crisis, it is currently primarily about demand inflation. Demand inflation is easier to influence with restrictive monetary policy measures. With the base period effect, slowing pressures on wage growth, and already pronounced price growth in the previous period, it is expected that price stability in services will gradually be established. Although service prices in 2023 were at 61.2 percent of the EU average, suggesting relatively large room for growth and convergence, it should be noted that restaurants and hotels, for example, already reached 90 percent of the average price level in the EU last year. Further price growth will largely depend on the dynamics of continued economic growth based on consumption and the positive sentiment of consumers themselves, influenced by a range of factors. All of this is a key risk for achieving short-term and medium-term inflation projections. Inflation expectations of companies in the service sector remain the only ones above long-term averages and clearly reflect the mentioned risks – they assess at RBA, concluding that they expect further slowing of the dynamics of overall consumer price growth in the remainder of the year, with a potential drop in the annual growth rate to around two percent. However, for the entire year, they expect inflation of consumer goods and services measured by the consumer price index to be around 3 percent. Further slowing and a drop below 2 percent is expected only in 2026. Under the influence of strong demand, core inflation (which excludes food and energy prices) is expected to remain above the general level of inflation until 2026.

Prices will obviously continue to dance at high levels, and a potential slowdown could come from stagnation in interest rate declines (the ECB recently did not further lower reference rates), primarily consumer loans that finance extravagant spending.