CNB continues to tighten monetary policy

At its February meeting, the Bank Board increased the two-week repo rate to 4.50%. The decision is based on the CNB’s winter macroeconomic forecast and responds to persisting exceptionally strong foreign and domestic inflation pressures. Consistent with the forecast is a substantial rise in market interest rates at the start of this year. Inflation will go up further, nearing 10% in the first half of 2022. This will reflect growth in gas and electricity prices and a further surge in core inflation, among other things. Inflation will start to decrease in 2022 Q3 as the current exceptionally strong price pressures subside, aided by a tightening of the domestic monetary conditions. Inflation will drop rapidly in late 2022 and early 2023 and fall close to the 2% target in the first half of 2023, i.e. over the monetary policy horizon. According to the Monetary Department, the risks to this outlook are inflationary overall. The main upside risks are weaker anchoring of inflation expectations and slower appreciation of the koruna as a result of a sharp tightening of monetary policy abroad. By contrast, consolidation of public finances is a slight downside risk to inflation.

The Czech economy is facing a combination of exceptionally strong inflation pressures causing escalating and broad-based price growth. Domestic inflation has exceeded long-term highs in recent months. Consumer prices are being driven up by rising costs of domestic producers and service providers – reflecting domestic and foreign factors, including growing energy prices – and by strong demand from Czech households and an overheated labour market.

The high consumer price inflation seen at the close of last year was driven primarily by core inflation, with fuel and food prices also rising. Core inflation will go up further in the months ahead. Traditional repricing in January, amid strong demand, will reflect the sizeable previous growth in firms’ personnel and material costs and the recent rise in energy prices on commodity exchanges. The contribution of the increasing costs of owner-occupied housing (imputed rent) to inflation will remain significant. Moreover, households’ living costs will be adversely affected at the start of 2022 by a rise in monthly energy bills, reflecting the autumn surge in international prices of electricity and gas. In addition, their effect will no longer be dampened by the temporary waiver of VAT on these two commodities, which ended at midnight on New Year’s Eve. Food price inflation, which also went up at the end of 2021, will stay high in the first half of this year. It will then slow and turn negative next year, due to movements in world prices of agricultural and food commodities. Fuel price inflation will initially remain high but will gradually start to fade, owing to a slight decrease in oil prices and appreciation of the koruna. Further increases in excise duty on tobacco will also foster higher headline inflation in 2022 and 2023.

As a result of the above factors, inflation will peak at nearly 10% in the first half of this year. It will then start to fall as growth in production costs slows, aided by an appreciating koruna, and as the stabilising effect of monetary policy manifests itself via domestic demand. Inflation will return close to the 2% target over the monetary policy horizon, i.e. in the first half of 2023.

Since the second half of last year, Czech firms have been facing rising growth in costs, driven largely by import prices. Their growth, caused by increasing foreign industrial producer prices, was joined in the autumn by a jump in prices of energy, most notably gas and electricity. However, the strong inflationary effect of import prices peaked at the turn of the year. Their growth will fade rapidly, due to a stabilisation and subsequent slight drop in energy prices, falling foreign industrial producer price inflation and an appreciating koruna. A decline in import prices will then start to dampen growth of total costs in the consumer sector.

Domestic factors contributed increasingly to the growth in Czech firms’ costs last year. Their inflationary effect will increase even further in early 2022, as wage growth will rise markedly in the quarters ahead. The Czech labour market cooled only partly during the pandemic and is now getting tighter again. The unemployment rate fell further last autumn, and the rising labour demand is coming up against labour shortages. The overheated labour market and high inflation will thus be reflected in wage agreements, causing wage growth to rise. This will also be fostered by rising labour productivity and a further increase in the minimum wage and the cascade of guaranteed wages above it. Earnings will thus outpace their steady-state growth rate over the next two years. Despite that, they will initially lag behind inflation, so real wages will decline in 2022.

The Czech economy will continue to operate amid an ongoing pandemic and persisting problems with global logistics and material and component supplies. Despite more high numbers of positive cases, the forecast does not expect the government to introduce measures having a significant dampening effect on domestic economic activity. By contrast, the problems in global production and supply chains, which are being felt strongly in the highly industrial Czech economy, will persist this year. However, their impact on GDP will be smaller than in autumn last year and will gradually disappear during the second half of the year. Fiscal policy will slightly dampen economic growth this year, as the measures previously adopted to support the economy are being phased out. The forecast expects a neutral effect of fiscal policy next year.

Economic growth will be driven largely by household consumption. The initially very high year-on-year growth of the latter will be due to last year’s low base. Growth in nominal household income will remain more than solid throughout the year and will continue to be supported by strong wage growth. Household income will also be boosted by a further reduction in income tax, increases in pensions and expanded housing benefits. Consumer expenditure will also be financed by continued gradual spending of the forced savings accumulated in the past two years. However, family budgets will be faced with broad-based high price growth. Rapid spending of income and savings, due to concerns of a loss of purchasing power, will be slowed by continued growth in interest rates and lower consumer appetite. By contrast, relatively favourable business sentiment and recovering external demand will result in a solid pace of fixed investment growth, driven by firms’ efforts to automate production. Government investment will also rise steadily, supported by absorption of EU funds. However, stocks of unfinished products will be highly volatile, due to logistics problems. The export performance of the Czech economy will continue to be undermined in 2022 by persisting supply bottlenecks and subsequent problems with completing and shipping export items. After the overloading of production and supply chains fades away next year, exports will make a significant contribution to GDP growth. The Czech economy will grow by 3% overall this year and will gradually return to its pre-pandemic level. The growth will accelerate next year.

The domestic economy is overheating again. In addition to strong domestic demand pressures, this is due to supply constraints slowing potential output growth. Interest rate increases are reducing the pass-through of the current exceptional inflation pressures to inflation in the longer term. They are also helping to anchor inflation expectations and will ultimately lead to inflation declining close to the target over the monetary policy horizon. This will also be fostered by marked appreciation of the koruna in the first half of 2022, reflecting a further widening of the interest rate differential vis-à-vis the euro area. The fall in inflation pressures in the Czech economy and the outlook for a decline in inflation to the target mean that the CNB’s interest rates will able to start decreasing towards their long-run neutral level in roughly the middle of this year.

Weaker anchoring of inflation expectations to the CNB’s 2% target is an upside risk to the outlook for a return of inflation to the target as outlined above. Slower appreciation of the koruna as a result of a Fed-led sharp tightening of monetary policy abroad or an escalation of the situation in Ukraine would also lead to a slower or later decline in domestic interest rates. Consolidation of public finances, especially next year, is a slight downside risk to inflation. The uncertainties include the extent of repricing of goods and services this January and the duration of the overloading of global production and supply chains.

Chart – Inflation will stay well above the upper boundary of the tolerance band this year and decline close to 2% over the monetary policy horizon
headline inflation; y-o-y in %; confidence intervals in colours

The monetary policy horizon is 12–18 months ahead. This is the period when the Bank Board’s current decision has the greatest impact on inflation.

Table – Domestic economic activity will rise by 3% this year and accelerate next year
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets