This paper tries to assess the role of international commodity price shocks, cyclical fluctuations, catching up and transition related factors—such as price deregulation, price convergence, and Balassa-Samuelson effects— in driving inflation in 18 European emerging economies. It examines the determinants of both headline inflation and its main components—energy, food, and core inflation—using country specific VARs, as well as panel models, and analyses inflation prospects in the region in the short and medium term.

Two VAR models are estimated at monthly frequency for 16 European emerging economies over the period mid 1990s-early 2008. The first includes world fuel and food price inflation, changes in the industrial production index, as a measure of economic activity, headline inflation, the 3-month money market rate, and changes in the nominal effective exchange rate. In the second model, headline inflation is replaced by its main three components— domestic energy inflation, domestic food inflation, and core inflation. Both models are “near” VAR, as international food and fuel prices depend only on their lagged values, and not on domestic variables.

A panel model for 18 European emerging economies is also estimated using quarterly data. It includes among the regressors the lagged dependent variable (whose coefficient is modeled as a country specific parameter), the output gap, interest rates, consumption tax rates, the nominal effective exchange rate, measure of trade openness (also interacted with the GDP gap) to account for the impact of globalization, indicators of price liberalization and competition, and variables capturing price and income level convergence.

The analysis indicates that that international food and oil price shocks have a significant impact on domestic inflation, and explain on average about 19 percent of the variation in headline inflation. Headline inflation response to commodity price shocks seems to be asymmetric. On average, in the long run, a 1 percentage point surge in oil price inflation leads to an increase in headline inflation by 0.02 percentage points, whereas a decline in oil price inflation by the same amount results in a drop in headline inflation by 0.04. A 1 percentage point hike in food price inflation generates a 0.06 percentage point increase in inflation, but falls in food price inflation do not appear to have a significant impact on headline inflation.

Cyclical fluctuations, while contributing to inflation, explain on average only 5.3 percent of inflation variability. The sensitivity of headline inflation to the output gap appears to have been falling in the wake of higher trade integration. The inflation response is found to be asymmetric during cyclical upturns and downturns. Inflation inertia, changes in consumption tax rates, nominal effective exchange rates movements are also important inflation drivers. While price liberalization and movements in the relative price in the tradable and non tradable sector do not appear to be a contributing factor to inflation in emerging Europe, price convergence is estimated to add about 2.8 percentage points to headline inflation, on average, and is likely to remain source price pressures in the medium term.