CNB puts the brakes on inflation

At its November meeting, the Bank Board increased the two-week repo rate to 2.75%. The decision is based on the CNB’s autumn macroeconomic forecast. The forecast expects inflation to rise significantly further and approach 7% at the start of next year. Consistent with the forecast is a sharp rise in market interest rates at the end of this year and at the start of 2022. Coupled with the rise in interest rates, a fade-out of the current exceptionally strong inflation pressures in the domestic and foreign economies will cause inflation to start slowing next year. In late 2022 and early 2023, i.e. over the monetary policy horizon, inflation will fall close to the 2% target. Lengthier overloading of global supply chains, which, together with a weaker exchange rate and higher growth in energy prices and imputed rent, could result in even higher inflation than forecasted, is a risk to this outlook. Fiscal restriction in 2023 is a slight risk in the opposite direction if public finances undergo consolidation.

The recovery that began when the economy reopened in the spring continued into the summer. However, the year-on-year growth of the economy slackened considerably due to base effects. Besides a continued recovery in household consumption, the economy was supported by robust growth in private and public fixed investment and government consumption. By contrast, the previously solid export growth slowed significantly due to escalating problems with supplies to the export-oriented Czech industry, which could not produce the quantities demanded and had to store part of its unfinished output. Persisting overloading of global production and supply chains and ensuing problems with supplies to domestic industry will continue to weigh on the Czech economy’s production and export performance at the end of this year. By contrast, epidemiological measures, which may be imposed in the autumn due to a resurgence of coronavirus cases, will have no tangible economic impacts.

With significant fiscal support, the domestic labour market has coped relatively well with the effects of the pandemic and is getting increasingly overheated again. Fundamental wage growth (i.e. wage growth adjusted for statistical and one-off effects) in market sectors slowed in 2021 Q2 but accelerated again in the summer. In addition, the decline in total employment has halted and the share of unemployed persons is falling markedly again. Firms are reporting large numbers of vacancies, and the reopened services sector in particular is facing labour shortages.

Inflation rose well above the upper boundary of the tolerance band around the CNB’s target in 2021 Q3, amid rising core inflation. Within this component, the contribution of the cost of owner-occupied housing (imputed rent), which has a relatively high weight in the domestic consumer price index, increased dramatically. This reflects the current high growth in prices of construction work and materials, and long-running rapid growth in property prices. The marked pick-up in headline inflation also reflects a surge in consumer demand following the lifting of anti-epidemic measures in both the services and goods sectors. By raising their prices, firms are making up partly for the low or zero sales they recorded during the shutdowns and for growth in their costs. The latter stems both from the domestic economy and from abroad, where industrial producer prices are rising apace due to supply chain disruptions. This is being accompanied by a significant rise in prices of energy, commodities and materials. Domestic food price inflation also picked up at the end of the summer. In addition, administered price inflation can be expected to rise sharply at the start of next year on the back of a surge in electricity and natural gas prices on commodity exchanges. Its acceleration will be only slightly postponed by a temporary waiver of VAT on electricity and gas for households at the end of this year. Fuel prices also continue to record significant year-on-year growth due to global oil prices and base effects.

At the close of the year, the Czech economy is facing problems with supplies of components from abroad, which are leading to production constraints and plant shutdowns, especially in the automotive industry. However, this will have no major negative impacts on the rest of the economy, thanks partly to immediate fiscal support. Moreover, these complications will fade out in the first half of 2022. This will be reflected in a recovery in exports and a subsequent relatively swift renewal of economic growth.

Following an increase in GDP of around 2% this year, the Czech economy will grow by almost 4% in the next two years. Economic activity will thus return to the pre-pandemic level at the end of 2022. Besides the effect of recovering exports, the economy will be supported by steady growth in private and government investment. It will also benefit from a continued rise in household consumption, supported (especially to begin with) by spending of previously created forced savings.

The solid income situation and consumer appetite of households will continue to stem mainly from the still very good shape of the domestic labour market. Unemployment will continue to decline. Adjusted wage growth will temporarily accelerate further in early 2022, aided by a further marked rise in the minimum wage.

The previously expansionary fiscal policy will turn restrictive next year due to the discontinuation of government support measures, despite another higher-than-usual increase in pensions. In 2023, fiscal policy will have a neutral effect on GDP growth given the measures approved so far on both the revenue and expenditure sides of public budgets.

Inflation will rise further in the months ahead, moving well away from the upper boundary of the tolerance band around the CNB’s target. This will be due to a combination of several strong inflationary factors. Food price inflation will increase further as a result of growth in agricultural commodity prices. Core inflation will also rise further, driven by fading rapid growth in foreign producer prices, which is interacting with solid domestic demand. The contribution of imputed rent to core inflation will remain significant as well. The rise in prices of electricity and natural gas will cause administered price inflation to surge at the start of 2022. Inflation will also be supported by continued high year-on-year growth in prices at filling stations due to high oil prices.

The desired inflation turnaround will occur in the course of next year. Foreign producer price inflation will ease substantially as the disruptions to global supply chains abate. The high growth in fuel prices will also fade as global oil prices stabilise. Appreciation of the koruna against the euro will support these two foreign factors in putting downward pressure on domestic inflation. The domestic sources of the current exceptionally high inflation will also start to dissipate gradually. The profit margins of goods sellers and service providers will fall over time as households and firms gradually take the growth in real interest rates into account in their decisions. This will reduce their consumption appetite and willingness to accept rapid price growth. Growth in domestic costs will also slow over time as the anti-inflationary effect of rising labour efficiency resumes and wage growth gradually stabilises.

Owing to the tightening monetary conditions and the fade-out of this year’s price growth, headline inflation will fall relatively quickly in the second half of next year. It will decline close to the CNB’s 2% target over the monetary policy horizon, i.e. in late 2022 and early 2023. Monetary policy-relevant inflation will be slightly below headline inflation over almost the entire horizon, due mainly to an increase in excise duty on cigarettes.

Continued exchange rate appreciation will be fostered by a widening positive interest rate differential vis-à-vis the euro area, amid a gradual fade-out of the current problems in industry during 2022. Domestic interest rates can be expected to rise sharply at the end of this year and at the start of 2022. This reflects a need to react to the combination of exceptionally strong price pressures in the domestic and foreign economies and prevent them from passing through to inflation in the longer term. The CNB’s response will also help anchor inflation expectations. During 2022, a gradual decline in interest rates towards the 3% long-run neutral level will become possible, as inflation will have started to decrease towards the target thanks to the forceful monetary policy tightening.

Chart – Inflation will rise well above the upper boundary of the tolerance band in late 2021 and early 2022 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 – Despite a wobble at the year-end, domestic economic activity will rise by around 2% this year and accelerate in the next two years
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets