Inflation is falling – an interim assessment of the disinflation process in the Czech Republic

This blog article follows up on a lecture by Governor Aleš Michl at the University of Economics and Business in Prague. We map the main elements of monetary policy transmission to illustrate how inflation in the Czech economy will return to the CNB’s 2% target. Monetary conditions are tight by historical standards and are dampening demand for loans. Positive ex ante real rates are also fostering a real decline in household consumption, which is crucial for the future course of inflation. Weak domestic demand is dampening growth in prices, which has been visible in all the monitored indicators of price developments (inflation momentum) for several months now. However, inflation is still at unacceptable levels and the CNB’s fight against it is not over.

Monetary conditions in the Czech economy are the tightest in twenty years

The CNB’s repo rate in nominal terms is the highest since May 1999. However, real rates in particular are important for households and firms when deciding whether to save, spend or invest. They show us how much savings will yield in the next year after adjustment for inflation (or, similarly, how much a loan will cost in interest). So, if the inflation outlook is falling, monetary conditions are tightened further, although the nominal interest rate remains at 7%.

And that’s what is happening now. Real rates in ex ante terms (with expectations taken from the FMIE – Financial Market Inflation Expectations – survey) reached distinctly positive levels after more than ten years in early 2023. They are now the highest since the measurement of inflation expectations started in 1999.

Chart 1 – CNB two-week repo rate

The exchange rate is the other component of monetary conditions. In recent months, the koruna has been close to its all-time highs. The average exchange rate in April even reached the strongest level since the establishment of the euro area.

Chart 2 – CZK/EUR exchange rate

The combination of the two components of monetary conditions is captured by the monetary conditions index compiled by the Monetary Department. The index also shows that the effect of the CNB’s monetary conditions is the tightest since the index was constructed. More details on the monetary conditions index are available in a blog article by Jan Frait and Jakub Matějů.

Chart 3 – Real monetary conditions index

The tight monetary conditions are dampening the quantity of money in the economy and household consumption

The share of the quantity of money in the economy in nominal GDP exceeded the long-term trend during Covid. GDP declined, while the quantity of money in the economy increased, owing mainly to the government’s Covid measures financed by new debt. Households could not spend their income during the lockdowns and, moreover, generated precautionary savings due to concerns about the future. Firms realised this, so when the economy was reopened after the lockdowns, they raised their prices in reaction to cost shocks. More information on this effect is available in our blog article.

However, the tight monetary conditions are now dampening growth in the quantity of money in the economy. The share of money in GDP is thus gradually shifting below the trend and dampening inflation.

Chart 4 – Monetary aggregates /GDP

The final consumption of households, whose stronger growth would give businesses room to raise prices, fell for the sixth consecutive quarter. In our blog post we write that consumption had already started falling when inflation was only beginning to rise. Therefore, in our opinion, the current inflation cannot be perceived as a sign of an overheating economy in the upward phase of the business cycle, and the fight against it does not require monetary policy to be as tight as in the case of purely demand-driven inflation.

Chart 5 – Houselhold consumption in the Czech Republic an other EU countries

Looking at the most recent data, the real consumption of Czech households fell the most in cumulative terms among EU countries compared with the pre-Covid period, although core inflation is among the highest. However, the decrease in real consumption cannot be explained solely by high inflation. Nominal consumption is rising, but only at a similar pace as in countries with relatively low inflation. The decrease in consumption is thus causing demand pressures in the Czech economy to fade gradually.

Chart 6 – Relationship beetween a recovery in household consumption and core inflation

Falling household consumption suggests that households do not expect inflation to be high in the future. If elevated inflation expectations were manifesting themselves, households would be purchasing goods (especially durable goods), as they would be expecting their prices to rise in the future.

Moreover, the saving rate suggests that, on average, households could afford these expenditures. Interestingly, the saving rate went up at the end of last year, reaching the highest level among the EU countries for which the data are available in the Eurostat database.

Chart 7 – Household saving rate

The fall in consumption leaves no room for further rapid price growth

The decrease in supply and demand pressures in the economy has been reflected in inflation since October last year. This is best seen in “inflation momenta” which show the current developments in the change in the price level. By contrast, the media favourite, year-on-year inflation, shows the change in the price level in the last 12 months and is therefore a significantly backward-looking indicator. We definite momentum as the moving average of three consecutive annualised seasonally adjusted month-on-month changes in prices. This definition sounds very abstract but it is simply the average rate at which prices have increased from month to month in the last three months. The measure is comparable to year-on-year inflation.

The momentum of core inflation (i.e. inflation excluding the volatile components food, energy and tobacco) peaked at 17% in May 2022. It is currently at 7%.

Chart 8 – Momentum of core inflation

There are tradable (goods) and non-tradable (services) components in core inflation. The momentum of the trend-cycle component (component which captures longer-term trends) of tradables peaked last February (16.5%), then gradually declined to 7.6% in April this year. The momentum of non-tradables did not peak until June 2022 (15.9%) and fell to 6% in April 2023.

Chart 9 – Momentum of the trend-cycle components of inflation

There are components in core inflation that may reflect global trends, for example, a drop in electronics prices – this is why the momentum of tradables was negative in the chart for a long time. At the same time, other components of core inflation may reflect the movement of commodity prices (for example, transport prices). The third indicator therefore only shows those components which are correlated with demand in the economy, i.e. the momentum of demand-pull inflation. This indicator peaked in June last year (8%). It fell to 1.6% in April this year.

Chart 10 – Demand-pull and core inflation

The road to the target

We are on the right track. Monetary policy is dampening the remaining demand pressures in the economy and all the monitored indicators of price growth are falling. However, inflation is still at levels which the CNB will not tolerate and will fight against with tight monetary policy.

The good news is that according to our new forecast, inflation will fall close to the inflation target next year if the economy evolves in line with the assumptions of the forecast.

We are currently living in a rapidly changing world. Therefore, the Bank Board will continue to assess new information and the effect this information has on future inflation at all its monetary policy meetings. The Bank Board is ready to raise interest rates, especially if the risk of growth in demand pressures increases. We will thus achieve our inflation target of 2% with tight monetary policy.