Inflation will rise temporarily to 3% at the turn of the year, then gradually decrease to the CNB’s 2% target

At its November meeting, the Bank Board lowered the two-week repo rate by 0.25 pp to 4%. Inflation has been close to the 2% inflation target for most of this year. However, it increased to 2.6% in September and will rise just above 3% temporarily at the turn of the year. This acceleration is due mainly to food prices, whose renewed growth will strengthen further in the months ahead. By contrast, core inflation adjusted for volatile food items, energy and administrative effects remains slightly above 2%, reflecting a slow unwinding of the downturn in demand in the domestic economy and abroad. Inflation will start to fall again gradually at the start of 2025 and stabilise close to the target in 2026, owing to lower growth in administered prices and later also food prices. Economic growth is recovering gradually, aided not only by household consumption amid renewed growth in real wages, but also by general government consumption. Inventories and subdued external demand are having the opposite effect. Economic growth will rise to 2.4% next year, driven by renewed investment growth, a further strengthening of household consumption and a recovery in our main trading partner countries. Consistent with the autumn forecast is a continued decline in short-term market interest rates initially, followed by broadly stable rates from mid-2025 onwards. A still tight interest rate stance will support the stabilisation of inflation close to the target over the monetary policy horizon. However, the need for monetary policy restriction will decrease as inflation pressures ease. The Bank Board assessed the risks and uncertainties of the outlook for the fulfilment of the inflation target as modestly inflationary overall.

Inflation has been exactly at, or close to, the CNB’s 2% target this year. In recent months, however, it has recorded slight growth, which will continue at the year-end. Inflation will briefly rise slightly above the upper boundary of the tolerance band around the target at the turn of the year, on the back of renewed growth in prices of food, beverages and tobacco, which will rise further over the next few months. In year-on-year terms, this will be due not only to the fact that food prices were falling this time last year, but also to the gradual pass-through of higher prices of some food commodities.

By contrast, administered price inflation will slow sharply to less than 2% next year. The announced reduction in the commodity component of housing-related energy prices will be offset by an increase in other items, such as licence fees. Fuel prices will continue to decline year on year this year and the next.

By contrast, core inflation is stable slightly above 2% and will stay close to this level in the coming years. This reflects not only fading cost pressures, but also subdued demand in the Czech economy, which is manifesting itself in a decrease in the until recently highly elevated profit margins.

Within core inflation, services prices are rising more quickly than goods prices. Persistent elevated growth in prices of market services is making headline inflation more susceptible to shocks in volatile items, as illustrated by the renewed food price inflation in recent months. A scenario considering a slower decline in profit margins, implying faster-than-forecasted growth in services prices, has therefore been constructed. The scenario leads to higher inflation next year despite tighter monetary policy in the form of higher interest rates.

Another risk of the forecast – a higher-than-expected recovery in demand on the housing and mortgage markets – is also linked with prices. Further growth in demand for mortgage loans would mean additional money creation and create an environment for the emergence of disequilibria in the economy. This risk is discussed in detail in the Appendix.

The economy has started to grow again this year. The recovery is being driven by household consumption, although its growth is weak compared with the solid growth in real income. This is because the saving rate remains significantly above average, with saving still being motivated by elevated real interest rates in addition to weak consumer confidence. As a result, household consumption will grow at a solid pace next year. It will be supported by still low unemployment and continued solid nominal wage growth, which, however, will be lower than in the previous two years.

Investment activity has been subdued so far this year. It mainly reflects a negative contribution of additions to inventories, with the level of inventories even falling. This is due to renewed smooth functioning of supply chains, which has enabled firms to complete and export their unfinished products and is no longer forcing them to hold excessive stocks of inputs.

Growth in fixed investment will also pick up as external demand gradually recovers and interest rates continue to fall in the domestic economy and abroad. By contrast, net exports of goods and services will make a negative contribution to economic growth as import-intensive investment and consumption rise.

General government consumption is continuing to rise strongly this year but will slow in the coming years. The government’s consolidation efforts are reflected in a restrictive fiscal impulse this year. This is visible most of all in a decrease in household consumption and reduces GDP growth by 0.7 pp. Next year, government measures will have a broadly neutral effect on economic growth.

External demand will recover only very slowly. Moreover, even this modest recovery is not risk-free. An escalation of the problems in German industry would adversely affect other EU economies, including the Czech Republic. This risk is quantified in another scenario, which involves continued stagnation of the German economy with spillovers to other countries, coupled with disinflationary tendencies and a faster decrease in ECB rates in line with their current market outlook. The scenario is therefore in many respects close to the current view of the financial markets, which, however, often tend to be overly pessimistic. For the Czech economy, the scenario implies markedly slower economic growth, especially next year, lower inflation pressures and a deeper decline in interest rates to below their long-run neutral level.

By contrast, the baseline scenario of the forecast assumes a slower decrease in the ECB’s rates next year, in line with its communications so far. This expected cautious approach will reflect an increase in euro area inflation at the turn of the year and persisting elevated growth in services prices, like in the domestic economy.

These overall developments are consistent with a slight weakening of the exchange rate. According to the forecast, the rate will be around CZK 25.50 to the euro on average over the next two years. This reflects a very slow recovery of external demand, muted domestic productivity growth and a narrowing interest rate differential vis-à-vis the euro area. The equilibrium rate of appreciation of the koruna has also been reduced starting with the summer forecast.

Consistent with the autumn forecast is a continued decline in short-term market interest rates initially, followed by broadly stable rates from mid-2025 onwards. Despite the decline in rates, their effect – with regard to inflation and inflation expectations – will remain restrictive until the start of next year and support fulfilment of the inflation target over the monetary policy horizon.

The Bank Board assessed the risks and uncertainties of the outlook for the fulfilment of the inflation target as modestly inflationary overall. Higher-than-expected inertia in services inflation is an inflationary risk. Potential excessive growth in total public sector spending would lead to a risk of the state budget having an inflationary effect. Increased wage demands in the private and public sector are an additional upside risk. An inflationary risk in the longer term is a potential acceleration of money creation in the economy stemming from a significant recovery in lending activity, especially on the property market. By contrast, a downturn in global economic activity and weaker German – and hence Czech – economic output are a significant downside risk to inflation. This is also reflected in the outlook for further rate cuts by major central banks.

Chart – Inflation will be close to the upper boundary of the tolerance band around the target at the turn of the year and will then start to decline gradually towards the 2% target
headline inflation; y-o-y in %; confidence intervals in colours

Table – The Czech economy is returning to growth this year and will accelerate to 2.4% in the next two years
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets