Inflationary risks warrant caution, interest rates remain unchanged

The high inflation continues to recede. However, in October, the decline will halt temporarily and annual inflation will jump due to a statistical effect linked to the inclusion of the energy savings tariff in the consumer price index last year. In January, however, this effect will drop out and annual inflation will fall to the upper bound of the tolerance band around the target. The ongoing disinflation reflects both the fade-out of the sizeable price shocks seen in recent years and a significant cooling of domestic inflation pressures. This is also apparent in falling core inflation, which primarily reflects the dampening effect of the tight monetary policy stance. With an outlook for low inflation next year, the moment at which continuing with the current monetary policy stance could have an excessively tight effect has moved closer. Consistent with the baseline scenario of the Monetary Department’s forecast, therefore, is a decline in interest rates from 2023 Q4 onwards. The Bank Board assessed the risks of the forecast and the uncertainties of the outlook as being significant and tilted to the upside. Still elevated inflation expectations, which could manifest themselves in stronger repricing of goods and services at the start of next year and in wage bargaining, are the main risk. The Bank Board therefore left the two-week repo rate at 7%.

Inflation continues to fall. Annual consumer price inflation slowed to 6.9% in September. To assess the pace of the decline in inflation, it is important to look at month-on-month inflation. It has been very subdued for more than six months now. The current annual inflation is therefore mostly an aftershock of the growth in prices recorded right at the start of this year, which was caused largely by rising energy prices. The decline in inflation is due to the fade-out of the earlier external cost shocks associated with the energy crisis, the supply chain disruptions and the unavailability of materials and components, and to diminishing domestic inflation pressures. Annual inflation will fall to 3% at the start of next year.

The Czech economy is going through a downturn this year. This is linked predominantly with a drop in household consumption, reflecting a deep decline in the real purchasing power of wages in the previous high-inflation episode. The growth of the Czech economy is also being dragged down by decreasing additions to inventories, which are returning to normal after the value chain disruptions. Growth in general government consumption, the contribution of net exports and renewed growth in fixed investment are having the opposite effect.

The economy will begin to grow again gradually in the next few quarters. Next year, it will record growth of 1.2%, despite the restrictive effect of fiscal consolidation. In 2025, the growth of the Czech economy will rise to almost 3%. The renewed growth will be due mostly to a recovery in consumption by households as their real income starts to rise again. The current negative contribution of additions to inventories will shrink as well. On the other hand, the positive contribution of net exports will diminish. This will reflect not only renewed demand of Czech firms and households for imported goods and services, but also quite subdued (though gradually rising) export activity. The latter is linked primarily with demand from other countries, especially Germany. Box 1 discusses the nature of Czech-German trade relations. The analysis reveals that Czech firms may be more dependent on Germany than would be consistent with the latter’s share in mutual trade.

Growth in domestic demand, and especially in household consumption, will replace net exports as the driver of growth next year. In addition to the above-mentioned income growth, domestic demand will be supported by a gradual decline in the currently very high saving rate. It was due to lower consumption by medium- and high-income groups, as Box 2  illustrates. The consumption behaviour of this section of the population might be less dependent on income situation. As a result, the expected decline in the saving rate is also very gradual. However, the speed of decline in the saving rate and the related recovery in household consumption remain an uncertainty of the forecast.

Despite the downturn, the labour market remains tight. The unemployment rate is still very low by international standards. There are still more vacancies than people out of work. Total employment is also rising. The persisting labour market tightness is illustrated by the composite LUCI, a revised computation method for which is presented in Box 3. The forecast expects only modest growth in the unemployment rate towards its steady-state level. Nominal wage growth remains elevated this year amid still high annual inflation. The forecast expects high but steadily falling wage growth in the coming years, too. However, this will not hamper the fulfilment of the inflation target, as firms’ currently high profit margins, will simultaneously correct. The real purchasing power of wages will thus start to grow again gradually, boosting household consumption. However, wage growth is another uncertainty of the forecast.

After rising temporarily in the final quarter of this year, inflation will drop to 3% at the start of next year. At the monetary policy horizon, it will be close to the 2% target. The significant slowdown of inflation in January will be caused primarily by the fade-out of the growth in energy prices for households seen at the start of this year, which will drop out of the year-on-year comparison. Growth in food prices will also slow. Meanwhile, year-on-year growth in fuel prices will turn positive. Core inflation, i.e. inflation adjusted for the aforementioned volatile items, will stay above 3% in the first half of the year. This will be due in part to tax changes approved in a government consolidation package. These changes are broadly neutral in accounting terms, but their historically observed asymmetric effect (tax cuts immediately show up less in prices than tax hikes do) will keep core inflation elevated. Besides the uncertainty associated with the tax impacts, the effect of energy prices, which are rising again, on firms’ costs is also unclear.

The koruna has weakened in the second half of this year. It will depreciate slightly further at the start of next year due to a narrowing interest rate differential vis-à-vis the euro area. The subsequent modest appreciation of the koruna will primarily reflect recovering external demand and a related pick-up in the domestic economy and its export performance.

With an outlook for low inflation next year (including over the monetary policy horizon), the moment at which continuing with the current monetary policy stance could have an excessively tight effect has moved closer. The high interest rates have served their purpose, as lending has dropped sharply in the case of mortgages and koruna loans to corporations. Moreover, high interest rates abroad are now making euro-denominated corporate loans less attractive. Growth in money in circulation due to private demand for credit financing is thus relatively moderate overall. The inflation pressures in the Czech economy have diminished and will stay subdued for most of the next two years. Consistent with the forecast, therefore, is a decline in interest rates of approximately 0.5 pp already in 2023 Q4.

However, the forecast is subject to a number of uncertainties and risks, the balance of which is significant and tilted to the upside. The threat of inflation expectations becoming unanchored is the main upside risk to inflation. This could lead to increased wage bargaining demands and stronger repricing at the start of next year. This risk is described in a scenario that assumes 1 pp stronger repricing. This would be consistent with keeping rates at the present level until the end of the first quarter of 2024. A longer effect of expansionary fiscal policy is also an inflationary risk. By contrast, a stronger-than-expected downturn in economic activity in Germany and the potential impacts of globally tightened monetary and financial conditions are downside risks to inflation. The uncertainties of the outlook include the future course of the war in Ukraine and the Middle East, the prices of energy, and the future monetary policy stance abroad.

Taking into account the upside risks to inflation and all the other uncertainties, the Bank Board decided to leave the two-week repo rate at 7%. This decision ensures that inflation will decline towards the target even if the inflation pressures diminish more slowly than assumed in the baseline scenario of the CNB’s forecast.

Chart – Inflation will fall to close to the 2% target at the start of next year and stay there over the monetary policy horizon
headline inflation; y-o-y in %; confidence intervals in colours

Table – The economy is going through a downturn this year but will start to grow again next year
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets