Inflation will decrease rapidly this year

At its May meeting, the Bank Board kept the two-week repo rate unchanged at 7%. The decision is based on the baseline scenario of the CNB’s spring macroeconomic forecast. In the forecast, the central bank looks at a monetary policy horizon 12–18 months ahead. The horizon is thus currently formed by the second and third quarters of 2024. Consistent with the baseline scenario of the spring forecast is initially market interest rate stability at the current high level ensuring the fulfilment of the inflation target next year. With this in prospect, interest rates will be able to start coming down in the second half of this year according to the forecast. Domestic economic activity will remain subdued in early 2023, as Czech economic output will continue to be dampened by a sharp decline in the real income of households and sluggish growth in external demand. The economy will recover over the rest of the year. Domestic inflation will continue to decrease in spring and summer, dropping to single digits in the second half of 2023. Inflation will slow markedly further in 2024 and will be close to the CNB’s 2% target at the monetary policy horizon. The Bank Board assessed the risks and uncertainties of the baseline scenario of the spring macroeconomic forecast as being significant and going in both directions. Besides the baseline scenario, the Bank Board discussed two additional forecasting scenarios. These assume that interest rates will be kept at the current level for longer, and one of them, in combination with elevated inflation expectations, points to a risk of overshooting of the inflation target at the monetary policy horizon.

The price pressures in the Czech economy are easing. This is being fostered by a decline in global inflation pressures amid subdued external and domestic demand, which reflects the CNB’s tightened monetary policy. The inflationary effect of energy import prices, which were a significant cost factor last year, is fading quickly, supported by a strengthening koruna. By contrast, the continued growth in consumer prices is being driven more strongly by domestic costs. Their growth remains elevated due to buoyant wage growth.

Consumer price inflation started to decline in February, following a temporary increase at the start of this year related to a marked rise in administered price inflation.

Year-on-year growth in prices will continue to slow visibly during spring and summer. With each passing month, inflation will be more than one percentage point lower than in the previous month. It will thus be in single digits by the second half of the year. This trend will be interrupted briefly in Q4 owing to last year’s exceptional low base caused by the temporary effect of the government’s energy savings tariff. Once this effect drops out, inflation will fall sharply further at the start of 2024. It will thus return to the CNB’s 2% target at the monetary policy horizon, i.e. in 2024 Q2 and Q3, with all its components contributing. Core inflation continued to come down in 2023 Q1, and a further decrease will be fostered by falling foreign producer price inflation and cooling domestic demand. The contribution of imputed rent is still shrinking rapidly, reflecting a slowdown in construction prices and stabilisation of new residential property prices due to higher interest rates. Declining global agricultural commodity prices and domestic agricultural producer prices will foster a further slowdown in food price inflation. In March, fuel prices switched to a sharp year-on-year decline, which will continue until the end of this year owing to the high base caused by the start of the war in Ukraine last year. Administered price inflation will be high and volatile this year but will tend to decline gradually, as natural gas and electricity prices for households have started to fall below the government price caps thanks to a decrease in prices of these commodities on energy exchanges. Administered price inflation will drop sharply in 2024.

The Czech economy will expand slightly overall this year. The downturn seen in the second half of 2022 will linger into the first half of this year, mainly due to a continued fall in household consumption expenditure. Czech households are still facing a deep decline in real income, which is being only partly offset by government support. This, together with negative sentiment and a higher saving rate, is reflected in a continued decline in their consumption. Fixed investment will return to growth, driven by a still good financial condition of firms and later also recovering external demand. In addition, export activity will be supported by the fading out of problems in supplies of materials and components for production. The downturn in domestic demand will cause import growth to lag well behind export growth this year. The contribution of net exports to economic growth will thus be strongly positive. It will continue to support GDP growth slightly in 2024.

Fiscal policy will have a neutral effect on GDP growth this year, despite the fading out of part of last year’s support expenditure. This is because the effect of the ongoing government measures linked with the fight against high energy prices and the addition of a child-raising bonus to pensions will act in the opposite direction. In 2024, fiscal policy will dampen economic growth due to the termination of the support measures and an only slow start to the absorption of investment from EU funds in the new programme period.

The Czech economy is below its potential output level. The output gap will stay negative until around mid-2024. The labour market also cooled slightly further in late 2022 and early 2023 but will start to tighten gradually again. Employment and unemployment will be broadly flat this year. Therefore, the long-standing excess demand for labour will not decrease significantly further. Nominal wage growth rose at the start of this year and will remain high throughout 2023. The bargaining position of employees is still strong. Firms’ still good financial condition will also foster buoyant wage growth. Wages will thus partly catch up with the previous inflation. The wage bill will not increase markedly in real terms until next year.

The koruna has been appreciating for the most part in recent months. The only major exception was a short episode during March, when it weakened temporarily due to higher risk aversion on global financial markets caused by problems in the US and Swiss banking sectors. Better market sentiment associated with the fading negative foreign trade situation and the CNB’s readiness to prevent excessive exchange rate fluctuations fostered appreciation of the koruna. The koruna will weaken slightly in the second half of 2023 and in 2024, mainly as a result of a narrowing interest rate differential vis-à-vis the euro area. The latter will reflect continued tightening of ECB monetary policy, including a reduction of its balance sheet.

Consistent with the forecast is market interest rate stability initially, followed by a gradual decline from the second half of this year onwards. High interest rates at the start of the forecast will lead to the fulfilment of the 2% inflation target at the monetary policy horizon. CNB interest rates will be able to start coming down towards the policy-neutral level in the second half of this year.

A number of substantial risks and uncertainties are associated with the forecast. Still expansionary fiscal policy is having an inflationary effect. The threat of inflation expectations becoming unanchored and the related risk of a wage-price spiral also remain significant risks in the same direction. By contrast, a stronger-than-forecasted downturn in domestic consumer and investment demand is a downside risk. The general uncertainties of the outlook include the future course of the war in Ukraine, the availability and prices of energy, and the future monetary policy stance abroad.

Chart – Inflation will continue to fall rapidly this spring and summer and return close to the 2% target in early 2024
headline inflation; y-o-y in %; confidence intervals in colours

Table – Following modest growth this year, the economy will recover significantly next year
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets