We analyze the relationship between labor cost and inflation in selected economies in Central, Eastern and Southeastern Europe (CESEE) by using a medium-scale time-varying parameter vector autoregressive model. The proposed framework makes it possible to control for potential movements in the underlying transmission mechanisms, stochastic volatility and flexible model selection. We use our model to simulate the effect of an unexpected labor cost shock and assess the dynamic reaction of inflation over the estimation period. Our findings indicate that a 1 percentage point increase in unit labor cost translates into higher inflation rates in most countries considered. However, the magnitude of the inflation reaction is very heterogeneous across countries and over time: the lowest response was observed for Bulgaria between 2008 and 2012 and the highest median response for Hungary between 2005 and 2007 (more than 0.4 percentage points). Moreover, we find that the wage-inflation pass-through weakened after the global financial crisis for most countries under consideration.
