Rates will now rise steadily

The introductory section of the Monetary Policy Report entitled “The decision, and the current outlook and its risks” published a week in advance of the whole Report. The author of this section is Executive Director of the Monetary Department Petr Král.

At its August meeting, the Bank Board increased the two-week repo rate to 0.75%. This decision is based on the CNB’s new macroeconomic forecast. The forecast expects inflation to rise well above the upper boundary of the tolerance band around the CNB’s target in the next few quarters, driven by stronger inflation pressures from the domestic and foreign economies. Consistent with the forecast is a rise in market interest rates from the middle of this year onwards. The increase in rates will cause inflation to fall close to the 2% target at the end of 2022. Lengthier overloading of global supply chains, which could result in even stronger inflation pressures than forecasted, is a risk to this outlook. Conversely, possible faster appreciation of the koruna due to larger-than-expected capital inflows may pose an anti-inflationary risk. The risk of a larger rise in cases due to new strains of the coronavirus could lead to anti-epidemic measures being retightened. However, increasing herd immunity and the economy’s ability to adapt to the coronavirus mean that any restrictions should not have a tangible effect on the economy.

A retreat of the pandemic led to an easing of government anti-epidemic measures in spring and early summer. A reopening of retail and services helped the Czech economy to return to growth in Q2. Its year-on-year pace reached a historical high due to base effects. Besides a surge in household consumption, the economy was supported by a recovery in fixed investment and buoyant export growth. Czech export-oriented industry is still facing disrupted supplies of some commodities, materials and components, owing mainly to overloaded global production and supply chains.

A renewed gradual rise in confirmed cases may lead to an episode of tightened measures during the summer. However, this will not have a tangible economic impact. The anti-epidemic measures will be scaled down from autumn onwards as the population becomes sufficiently vaccinated. According to the forecast assumptions, only epidemiological recommendations and educational and information campaigns with no major impact on the functioning of society and the economy will persist into 2022.

The Czech labour market, which was cooling in previous quarters due to the pandemic, is gradually stabilising. Fundamental wage growth (i.e. wage growth adjusted for statistical and one-off effects) in market sectors slowed only slightly in 2021 Q1. In addition, the decline in total employment has moderated and the share of unemployed persons has even started falling in recent months.

Inflation was close to the upper boundary of the tolerance band around the CNB’s target in 2021 Q2, amid persisting strong core inflation. Prices of services and goods within core inflation are rising apace. Domestic inflation is still being affected by continued cost pressures from the domestic and foreign economies, showing up mainly as elevated growth in industrial producer prices. On the other hand, food price inflation has slowed markedly further. Administered prices are flat, with cheaper gas and electricity for households being offset by rising prices of other items (e.g. water supply and sewerage charges, and health care). By contrast, prices at filling stations are rising rapidly year on year in reaction to the recent sharp growth in oil prices.

The Czech economy will grow at a pace of around 4% on average in the second half of this year. It will benefit from renewed strong growth in household consumption, which will be supported – in addition to the return to normal life – by the spending of part of forced savings. The solid income situation and improved sentiment of households are due to the good shape of the Czech labour market and generous fiscal policy. The general unemployment rate will fall slightly in the second half of this year on the back of the reopening of the economy, which will cause the labour market to overheat again. Year-on-year growth in the average wage in market sectors will be volatile until mid-2022 due to statistical effects and extraordinary bonuses in health care. Year-on-year wage growth adjusted for these effects will start to accelerate in early 2022, aided by a further marked rise in the minimum wage.

Government financial support for pandemic-hit sectors, coupled with a rise in social expenditure and public investment and a reduction in taxes, is leading to continued fiscal expansion this year. Next year, however, fiscal policy will turn restrictive due to the discontinuation of government support measures, despite the announcement of another higher-than-usual increase in pensions. Fiscal policy will have a neutral effect on GDP growth in 2023.

The current problems in industry and international trade will subside gradually, temporarily supporting growth in Czech exports in late 2021 and early 2022. Its pace will stabilise close to 5% thereafter. Investment activity will recover significantly amid a continued rise in government investment and renewed growth in private fixed investment. Total gross capital formation growth will be temporarily slowed in late 2021 and early 2022 by a sharp drop in additions to inventories as currently unfinished cars are completed and forced stocks of other products are exported.

The domestic economy will grow by 3.5% overall this year. Next year, its growth will increase further to above 4% and the economy will return to the pre-pandemic level. The currently slightly negative output gap will close gradually. In 2023, economic activity will grow at its steady-state pace of 3%.

Inflation will rise well above the upper boundary of the tolerance band around the CNB’s target in the quarters ahead. This will be due to renewed growth in administered prices and faster growth in food prices amid still elevated core inflation. The latter will continue to reflect growth in foreign producer prices coupled with still solid domestic demand, rapid growth in imputed rent and a gradually improving labour market situation. In the summer, core inflation will also be buoyed temporarily by the immediate price effects of the reopening of the economy. A surge in consumer demand after the anti-epidemic measures are lifted will cause prices to go up, especially in services. By raising prices, service providers will try to improve their profit margins to make up at least partly for the low or zero sales they recorded during the shutdowns of the economy. Rising labour efficiency after the reopening of the economy will dampen the inflation pressures to only a limited extent. Until the end of this year, consumer price inflation will be supported by continued high year-on-year growth in fuel prices due to higher oil prices. A recovery in food price inflation, reflecting the recent increase in global commodity prices, will act in the same direction.

The gradual return of inflation to the 2% target in the course of next year will be aided by a decline in core inflation as the supply and demand situation gradually gets back to normal. A fall in the currently high year-on-year growth in fuel prices will have the same effect. Monetary policy-relevant inflation, i.e. inflation adjusted for the first-round effects of changes to indirect taxes, will be slightly below headline inflation over the entire forecast horizon owing to an increase in excise duty on cigarettes. The decline in monetary policy-relevant inflation towards the target at the end of next year and its subsequent stabilisation will also be supported by a tightening of both the exchange rate and interest rate components of the monetary conditions.

The recovery in aggregate demand, the fade-out of the temporary problems in domestic industry and improved sentiment will foster continued firming of the exchange rate. The appreciating koruna will also significantly reflect growth in the differential between domestic and euro area interest rates, as domestic monetary policy can be expected to foster a rise in interest rates in the second half of this year. This reflects a need to react to the increased price pressures from the domestic and foreign economies. The commensurate increase in domestic interest rates will cause inflation to decline close to the 2% target in the course of 2022. Interest rates will continue to rise – albeit more slowly – next year, when economic activity will return to the pre-pandemic level.

Chart – Inflation will initially rise well above the upper boundary of the tolerance band and decline close to 2% over the monetary policy horizon
headline inflation; y-o-y in %; confidence intervals in colours

The monetary policy horizon is 12–18 months ahead. This is the period when the Bank Board’s current decision has the greatest impact on inflation.

Table – Following a drop last year, the domestic economy will return to growth this year and pick up slightly further next year