Inflation will decrease rapidly to the 2% target

At its August meeting, the Bank Board kept the two-week repo rate unchanged at 7%. This monetary policy stance will ensure that inflation returns to the 2% target. The decline in inflation is broadly in line with the CNB’s previous outlooks. Annual consumer price inflation slowed to single digits in June and will continue to fall over the next few months. The downward trend in annual inflation will temporarily halt in the autumn, but only as a result of the statistical effect of the energy savings tariff applied at the end of last year. After it fades out, inflation will fall sharply to close to 2% at the start of next year. Its decrease is being fostered by the rapid unwinding of growth in foreign prices (especially energy prices, but also food commodity prices), which until recently were a significant source of growth in domestic costs. Demand in the domestic economy, which is being dampened by tight monetary policy, is also having an anti-inflationary effect. The deep year-on-year decline in household consumption is continuing and investment activity is also falling. The weak demand is creating conditions for a decrease in inflation, especially core inflation, and, in turn, inflation expectations. Consistent with the baseline scenario of the Monetary Department’s forecast is therefore a decline in market interest rates over the entire outlook. However, the Bank Board assessed the risks of the forecast and the uncertainties of the outlook as being significant and tilted to the upside. This assessment is underpinned by two additional scenarios. The first one illustrates the risk of a slower decline in inflation expectations in the domestic economy. The second one captures the risk of a stronger recovery in consumer demand arising from a rapid decline in the saving rate from its current high level.

The high inflation is receding. According to the June data, it has fallen to single digits (9.7%), with all its components contributing to the decline. This is due largely to fading inflation pressures from abroad. The decline in energy prices from last year’s extreme levels is helping to stabilise energy prices for households and – together with base effects – is also causing a marked year-on-year drop in fuel prices.

Core inflation is also falling. This reflects a number of factors, including restrictive monetary policy. A drop in real household income coupled with a high saving rate, is reducing households’ consumer demand (Box 1 discusses the causes of households’ higher propensity to save). In turn, the substantial year-on-year decline in private consumption is cooling the demand-pull inflation pressures.

The tight monetary policy stance has fostered an increase in mortgage interest rates and a marked cooling of the property market (Box 2 discusses the increased mortgage rates). The observed halt in the previous strong growth in new residential property prices is playing an important role in reducing core inflation by slowing growth in the cost of owner-occupied housing in the form of imputed rent.

According to the forecast, inflation will decline further in the summer months. The downward trend will then halt temporarily. However, this will be due solely to statistical base effects reflecting last year’s government support in the area of energy prices. The energy savings tariff which was in place from October to December 2022 temporarily lowered annual inflation and will conversely increase it this year. Inflation will fall sharply to close to the 2% target at the start of next year, despite a gradual depreciation of the koruna. The latter will be a result of further growth in foreign interest rates amid a decrease in domestic rates.

Domestic economic activity remains subdued. GDP is falling slightly year on year. This is due largely to households’ very weak consumer demand, which has been falling in absolute terms for six consecutive quarters. Its decline is due to a drop in real household income and a high saving rate. The latter reflects households’ caution stemming from the rapid growth in the cost of living and the elevated interest rates (the pass-through of monetary policy to client rates is described in Box 3).

So far, corporate investment has not provided a major growth impulse either. Like household consumption, fixed investment is being dampened by the high domestic interest rates. Rates on euro-denominated loans are meanwhile rising, making them less attractive to domestic firms than they were until recently. Additions to inventories, especially of materials, semi-finished products and unfinished production, are also weakening. This is linked with the renewed smooth operation of global supply chains.

Net exports and general government consumption are fostering economic growth. The contribution of net exports is a consequence of limited domestic demand dampening imports and of relatively robust Czech exports, which rose by 7% year on year in 2023 Q1.

Overall, economic activity will be broadly flat this year and return to significant growth next year. Faster growth will be countered next year by the government’s fiscal policy focused on reducing structural deficits in the form of a consolidation package.

Wage growth is currently elevated but remains negative in real terms. Looking ahead, still low unemployment will boost the bargaining power of employees, who will seek to regain their share of income in the economy as a whole. The rapid wage growth will therefore dissipate only gradually. However, this will not reverse the disinflation process.

The decline in inflation pressures from abroad and the subdued domestic economic activity, together with the current tight monetary policy stance, are creating a desirable environment for the ongoing process of domestic disinflation. Looking at current price developments, it is clear that the acute inflation pressures in the domestic economy have mostly faded out and annual inflation is heading towards the 2% target. In the baseline scenario, this situation is consistent with interest rates returning towards their neutral level. However, the price outlook is still subject to a number of risks.

Two scenarios have been prepared to capture these risks. The first one illustrates the risk of a slower decline in inflation expectations, which could delay the return of inflation to the target. The scenario takes into account the observed high inflation expectations of households, firms and analysts. It involves a slower return of expectations to the 2% target and the related implications for price-setting. In this scenario, even keeping rates at the current level is not sufficient to fully mitigate the impacts of elevated expectations and inflation remains well above the target for most of next year. Faster wage growth is also a contributing factor.

The second scenario captures the risk associated with the current high saving rate. A faster return of the saving rate to levels close to the long-run average would provide a significant impetus to household consumption, which has long been subdued. The subsequent stronger recovery in domestic demand leads to greater inflation pressures and a need for tighter monetary policy. Despite that, inflation converges to the target somewhat more slowly in this scenario as well.

Both scenarios thus call for caution with regard to easing monetary policy and support keeping rates at the current level.

The Bank Board assessed the risks of the forecast and the uncertainties of the outlook as being significant and tilted to the upside. The threat of inflation expectations becoming unanchored and the related risk of a wage-price spiral, which would lead to renewed demand-pull pressures and persistent inflation, are the main upside risks to inflation. A longer effect of expansionary fiscal policy is also an inflationary 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 fall sharply to close to the 2% inflation target at the start of next year
headline inflation; y-o-y in %; confidence intervals in colours

Table – The domestic economy will return to appreciable growth next year
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets