The study demonstrates that the ECB's single interest rate often diverges from the inflation and output gap of individual eurozone countries. This divergence is especially important in Croatia's case.
According to Eurostat's June flash estimate, Croatian inflation stands at 4.2%, compared with 2.8% across the eurozone. Meanwhile, the ECB has held its deposit rate at 2.25% and its main refinancing rate at 2.4% since last month.
Plugging this year's Croatian data into the Taylor rule used in the study yields a rate of around 4.9%. Croatia would therefore theoretically need a rate about 2.5 percentage points higher than the ECB's current main rate if it still had its own currency. Since it does not have such a high rate, inflationary pressures are mounting.
A second channel, tourism, is examined in a study published this year, that looks at how tourists' attitudes toward currency conversion have shaped their perceptions of prices since Croatia's entry into the euro area.
The authors surveyed 939 respondents to examine how the switch from the kuna to the euro changed tourists' attitudes toward Croatian prices, finding that more than four-fifths expected tourism prices to rise once the euro was introduced.
The euro therefore pushes Croatian inflation upward through two channels: the loss of independent monetary policy and rising inflation expectations among tourists, who increasingly perceive the country as less affordable.
In a sense, this became a self-fulfilling prophecy. Tourists expected prices to rise once Croatia joined the eurozone, and hoteliers and restaurant operators took advantage of their somewhat greater willingness to spend by raising prices accordingly. The ECB's overly loose monetary policy further fueled this trend, until prices began hitting a ceiling.
When the Euro Breaks the Price Illusion
Hitting the ceiling is more noticeable with the euro. This is because tourists can more easily compare prices in Croatia with those in other eurozone countries, such as Greece or Italy.
A third piece of the puzzle behind Croatia's high euro-era prices comes from last year's study by the University of Dubrovnik's Department of Economics and Business, which examines whether monetary contraction and rising interest rates have helped curb inflation in the Croatian economy. Joining the eurozone, the authors note, meant Croatia ceded its monetary policy to the ECB. That handover to Frankfurt cost the country the ability to implement stricter monetary policy, including tools such as mandatory minimum reserves, that could more effectively curb inflationary pressures.
The implication is clear. When Croatia's inflation runs significantly above the eurozone average while its interest rate is set at the same level as Germany's or France's, monetary policy is by definition too loose for Croatia's needs, and correspondingly ineffective at containing price growth.
Once tourists recognize that prices have been inflated by the euro, and denominated in euros no less, the price illusion breaks down. That quickly leads to canceled reservations, a shift toward last-minute deals and growing pressure to discount apartment rentals.
Originally published on the author's personal website lukaskovanda.cz.
