Inflation will stay close to the CNB’s 2% target over the entire forecast horizon

At its May meeting, the Bank Board lowered the two-week repo rate by 0.50 pp to 5.25%, thus continuing the monetary policy easing cycle that started at the end of last year. Consistent with the spring forecast is a further decline in market interest rates. This will help keep inflation close to the central bank’s 2% target over the entire outlook. Inflation fell markedly last year and the continued disinflation process culminated in the CNB’s target being hit in February and March 2024. The cooling domestic inflation pressures are apparent, among other things, in steadily falling core inflation, reflecting the dampening effect of the previous tight monetary policy stance. The decline in inflation is also being fostered by an only gradual recovery of domestic economic activity. This is a result of still increased caution of Czech households, fiscal consolidation and the economic difficulties of our largest trading partner, Germany. However, the dampening effect of these factors in the Czech economy will dissipate gradually and GDP growth will rise to 3% next year. The main factor that may hinder the decline in domestic interest rates is a potential later and slower reduction in foreign interest rates (by the ECB and above all the Fed) and its effect on the koruna. The slower pace of rate cuts than in the baseline scenario of the spring forecast reflects the Bank Board’s view that the risks and uncertainties are modestly inflationary overall and expresses its cautious approach to easing monetary policy. This approach will lead to the target being hit even if the inflationary risks materialise.

Price stability has been restored in the Czech Republic, as inflation fell to the CNB’s 2% target during 2024 Q1. This primarily reflected markedly slower growth in housing-related administered energy prices. A fall in food prices, resulting from a decline in agricultural commodity prices amid a muted recovery in the consumption of Czech households, acted in the same direction. Also important is the steady decline in core inflation, which is now into its second year. It reflects slowing growth in prices of foreign inputs and a previous lengthy downturn in domestic demand, due in part to tight CNB monetary policy. The profit mark-ups of producers, retailers and service providers over their costs are thus decreasing. Growth in services prices within core inflation remains elevated but no longer differs much from the historical norm.

According to the forecast, inflation will rise slightly in the spring months, due to higher fuel prices at filling stations and a more moderate decrease in food prices. Even so, it will be safely in the upper half of the tolerance band around the central bank’s target. Annual consumer price inflation will also be slightly above the CNB’s 2% target for the rest of this year and at the start of next year. This will be because administered prices will rise more rapidly this year, driven mainly by the January increase in electricity prices for households. Its effect will not fade out until next year. By contrast, the ongoing decline in firms’ profit margins amid moderating growth in their total production costs will have an anti-inflationary effect. As a result, consumer price inflation will be close to the CNB’s 2% target over the monetary policy horizon, i.e. in 2025 Q2 and Q3.

The Czech economy is beginning to recover from last year’s downturn. Growth in economic output will be driven by a recovery in private consumption growth due to renewed growth in households’ purchasing power. This will be supported by a gradual decrease in the saving rate and an increase in consumers’ buying appetite, which was generally cautious until recently. In addition, change in inventories will stabilise. However, the recovery of the Czech economy will be dampened this year by the consolidation package, which will cause fiscal policy to be restrictive in 2024. Fixed investment growth will remain solid this year despite a slow recovery in external demand, with Germany having a noticeable adverse effect. At the same time, growth in private investment activity will be dampened by restrictive foreign and domestic monetary policy. The latter, among other things, will slow the emerging housing market recovery. The positive contribution of net exports of goods and services to GDP growth will dissipate gradually this year despite a gradual recovery in external demand and hence in Czech exports. The domestic growth surge to 3% in 2025 will be based mainly on domestic demand, above all consumption expenditure by households and gross capital formation.

The tightness in the domestic labour market is decreasing only gradually. However, the unemployment rate, which has long been one of the lowest in the EU, is gradually starting to creep up. In early 2024, the number of job applicants exceeded the number of vacancies for the first time in a long time. The labour market will continue to cool gradually, owing to the lagged effect of the previous downturn in the domestic economy. However, given its resilience so far, this will imply a gradual rather than rapid rise in the number of unemployed persons. Wage growth in market sectors will remain solid this year, reflecting, among other factors, broad growth in wages, especially base pay rates. Coupled with base effects, this will lead to an upswing in year-on-year wage growth in the corporate sector in the course of this year. By contrast, pay growth in the public sector will be subdued owing to budgetary savings.

After depreciating at the turn of the year, the exchange rate stabilised around CZK 25.3 to the euro in March and April. Its further evolution will reflect, on the one hand, ongoing cuts in domestic interest rates and related market expectations of a continued narrowing of the interest rate differential vis-à-vis euro area rates. This will be counteracted by a rising goods and services surplus, against a backdrop of renewed real convergence of the domestic economy. As a result, the koruna will be very close to CZK 25 to the euro until the start of 2025 and appreciate slightly below this level over the rest of the year.

Consistent with the forecast is a further decline in market interest rates. Nonetheless, monetary policy will remain restrictive for most of 2024 via its interest rate component. This will lead to an anchoring of the renewed price stability in the Czech Republic amid declining cost growth and subdued demand-pull inflation pressures.

The Bank Board assessed the risks and uncertainties of the outlook as being modestly inflationary. A slower decline in the elevated inflation expectations is a risk in this direction. Given the tight labour market, this could be reflected in stronger wage demands. Higher-than-expected inertia in services inflation and a halt in tradables disinflation, which has so far been due mainly to fading supply-side problems, are additional upside risks. Movements in the koruna exchange rate, which could cause prices of imported goods to go up, are an upside risk to tradables prices. 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 stronger-than-expected downturn in global economic activity and weaker German economic output are a downside risk to inflation. The future monetary policy stance abroad remains an uncertainty of the outlook.

Chart – Inflation will be close to the CNB’s 2% target over the entire outlook, including the monetary policy horizon
headline inflation; y-o-y in %; confidence intervals in colours

Table – The Czech economy will start to grow again in 2024 and accelerate further to almost 3% in 2025
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets