Croatia Watch: Stubborn service inflation

In September, CPI fell to 1.6% yoy, recording the lowest increase since March 2021. Considering that Croatia recorded a continuous yoy increase of 4.1% in Q1 24, at first glance the average annual inflation of 3.0% in the first nine months could mean that the disinflation process might soon reach the targeted level of around 2%. But what is behind the curtain? The relatively strong disinflation after Q1 was primarily the result of lower prices for energy and industrial goods. The monthly rise in food prices is currently hovering around the long-term average, but inflation in services is causing headaches.

As a small and open economy, Croatia is very prone to external shocks, which are reflected in the domestic market with a certain time lag. After the end of the energy and food price shock, in 2024 we could see that energy prices have contributed strongly to disinflation, especially after May, and that food prices have given up their role as the leader of inflation growth.

To some extent, this disinflation contribution of energy prices is due to untargeted government measures introduced to help consumers and businesses in times of energy crisis and inflation shock. In September, the government announced that it would gradually adjust the administratively set prices for energy (gas and electricity prices) for households, which should push the CPI up to some extent by the end of the year. On the other hand, food prices could normalise further as we have already seen that monthly growth is at or close to the long-term average and follow the usual pattern of monthly developments. In addition, food prices have already reached the EU price average in 2022, so we do see a narrow or almost no existing space for convergence.

Some of Croatia's most important trading partners, such as Germany and Austria, are currently experiencing subdued economic activity. Sluggish industrial activity and subdued foreign demand from those markets are also reflected in domestic industry, which do not yet show any signs of a sustained recovery. In line with subdued demand, goods inflation contributed only 0.4pp to the overall rise in consumer prices in Jan-Sept 2024.

In contrast to the predominantly positive news stands the inflation in services prices. It contributed more than 50% to the overall rise in inflation in the first nine months. Suffice to say that despite lower goods inflation, core inflation in the period Jan-Sept 2024 stood at 3.8% yoy. A closer look shows that inflation is broad-based in the services sub-aggregates, but is particularly pronounced in one sub–aggregate: Restaurants and hotels. So what are the reasons for such a high aggregate? Put simply, it is a reflection of a strong labour market combined with strong, double-digit wage growth and a solid tourist season leading to strong domestic and foreign demand for various services, particularly restaurant and accommodation services.

This certainly has an impact on selling price expectations for services, as companies are able to pass on at least the higher input costs to end consumers. The Eurostat data therefore show that the business optimism of companies in the service sector is consistently above the long-term average.

Where could one find more evidence of the problem of service inflation in Croatia? Looking at the harmonised consumer price index, inflation in the first nine months of 2024 was 4.0% in Croatia and 2.4% in the euro area. This primarily reflects the difference in the structure of the average consumer basket and the stronger growth in service prices in Croatia. This is because the harmonised index also takes into account the consumption of foreign guests, and services are given a significantly higher weight in the calculation. Suffice to say that in September the growth of service prices accelerated to 8.2% compared to September 2023. This was the highest increase among the euro area member states.

Nevertheless, with the base effect, the expected slowing down of wage growth, the already pronounced rise in prices in the previous period and significantly narrowed space for price convergence, the price stability in services will be gradually established in the course of the next year. Further, price growth will largely depend on the dynamics of the continued growth of the economy based on consumption and the consumer confidence, which is influenced by a number of factors. The announced tax relief for wages and raising the minimum wage by 30% as 1^st of January are the most recent decisions that will support domestic demand in 2025. In addition, the previous increase in salaries in the public sector are likely to put pressure on the private sector as well. Eventually, threats from global (commodity) markets although not in the baseline scenario always lurk around the corner and could cause a new supply shock thus stopping the expected disinflationary process. For this year, we are sticking to our forecast of CPI at 3% yoy followed by further decline to 2.6% in 2025.