The Bank Board continues to cut interest rates cautiously

At its February meeting, the Bank Board lowered the two-week repo rate by 0.50 pp to 6.25%, thus continuing the process of gradual monetary policy normalisation. Consistent with the winter forecast is a rapid decline in market interest rates in the course of this year. This will lead to inflation stabilising near the 2% target and inflation expectations being anchored once the disinflation process is complete. Month-on-month inflation has been very subdued since mid-2023. The price level even dropped in December, testifying to the robustness of the current phase of the process of restoring price stability. The cooling domestic inflation pressures are apparent mainly in falling core inflation, primarily reflecting the dampening effect of the current tight monetary policy stance. Lower inflation is also being fostered by weak domestic economic activity – a result of low household confidence and consumption and the economic difficulties of our largest trading partner, Germany. Elevated inflation expectations, which may manifest as a slower decline in inflation this year, are still the main risk of the forecast. The slower pace of rate cuts than in the baseline scenario of the winter forecast reflects the Bank Board’s view that the risks and uncertainties are broadly 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.

The inflation pressures in the Czech economy continue to weaken. In December 2023, as in the previous two months, annual inflation was affected by the statistical effect of the energy savings tariff, and stood at 6.9%. Adjusted for that effect, inflation would have dropped to 4.2% in December. This confirms the robustness of the disinflationary trend. The decline in inflation reflects a slowdown in food price inflation, caused by falling agricultural commodity prices and subdued household consumption. Fuel prices are also falling as a result of a decrease in oil prices on global markets. Also important is the gradual decline in core inflation that has been going on for more than a year now. It reflects fading growth in prices of foreign inputs and cooling domestic demand. The latter is fostering a decrease in the profit margins of producers, retailers and service providers. To assess the pace of decline in inflation, it is important to look at monthly inflation, which has been subdued since around mid-2023.

According to the forecast, annual inflation will decline sharply towards 3% in January 2024. This drop will be due partly to the fade-out of the sharp price growth recorded in January 2023, as well as to the current tight monetary policy stance and stagnating economic activity. By contrast, an increase in the administered component of energy prices due to the abolition of government energy distribution subsidies and the reintroduction of fees for renewable sources will have an inflationary effect. Given the government’s consolidation efforts, fiscal policy will be restrictive this year. Its resulting anti-inflationary effect will be reduced by the slightly positive overall effect of increases in indirect taxes. Inflation will be below 3% for the rest of this year. At the monetary policy horizon, i.e. in the first half of 2025, it will be close to the 2% target.

The Czech economy underwent a downturn last year. It was connected primarily with a drop in private consumption due to a decline in households’ purchasing power and higher saving. The contribution of change in inventories to GDP growth was also negative. However, additions to inventories remained high by historical standards due to firms’ concerns about a potential return of supply chain disruptions. Still swift growth in general government consumption expenditure, a positive contribution of foreign trade and growth in fixed investment supported by co-financing from EU funds from the previous programme period had the opposite effect.

The economy will gradually start to grow again this year, although the growth will be dampened appreciably by domestic fiscal consolidation and Germany’s economic difficulties. As inflation goes down, real wages will grow for the first time in two years, becoming the main driving force of a recovery in household consumption. However, the saving rate will stay elevated due to persisting pessimistic expectations of households and still attractive returns on deposits. Total investment activity will remain weak due to diminishing additions to inventories, a sluggish recovery in external demand and the current restrictive monetary policy stance. The positive contribution of net exports of goods and services to GDP growth will dissipate gradually over the forecast horizon despite a gradual recovery in external demand and hence in Czech exports. The growth surge in 2025 will be based on domestic demand, above all consumption expenditure by households and gross capital formation. The latter is highly import-intensive and will therefore reduce net exports.

The domestic labour market remains tight. The unemployment rate has been among the lowest in the EU for seven years. The number of vacancies was roughly equal to the number of job applicants at the end of last year. The labour market will continue to cool gradually, owing to the lagged effect of the subdued real economy. However, given its resilience so far, this will imply a gradual rather than rapid rise in the unemployment rate. There are still several buffers on the labour market preventing sharper growth in the number of unemployed persons. These include a still high number of vacancies and a tendency of firms to first dismiss external (agency) employees, who may not be captured accurately in the statistics. Moderate wage growth will reflect a preference for job security over higher pay. Nominal wage growth will outpace inflation this year and the next.

The koruna weakened slightly in early 2024 because of the start of the rate-cutting cycle and market expectations of a continued narrowing of the interest rate differential vis-à-vis euro area rates. The forecast assumes the Czech currency will strengthen gradually from roughly mid-2024 onwards due to a rising goods and services surplus, against a backdrop of renewed real convergence of the domestic economy.

Consistent with the forecast is a rapid decline in market interest rates in the course of this year. Nonetheless, monetary policy will remain restrictive for most of 2024 via its interest rate component.

The Bank Board assessed the risks of the forecast and the uncertainties of the outlook as being broadly 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 higher wage demands. Higher-than-expected inertia in services prices and a halt in tradables disinflation, which has so far been due mainly to fading supply-side problems, are additional upside risks. An inflationary risk in the longer term is an acceleration of money creation in the economy stemming from excessive lending activity in the property market. The latter could lead to renewed highly positive contributions of imputed rent to core inflation. By contrast, a stronger-than-expected downturn in global economic activity and in German economic output is a downside risk to inflation. The future monetary policy stance abroad remains an uncertainty of the outlook.

Even if the above inflationary risks materialise, the CNB’s cautious approach to cutting interest rates guarantees that the domestic economy will return to price stability.

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

Table – Following a slight decline last year, economic output will increase this year
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets