The CNB cautiously lowers interest rates, inflation will be close to the 2% target over the monetary policy horizon

At its May meeting, the Bank Board lowered the two-week repo rate by 0.25 pp. Inflation was in the upper half of the tolerance band around the 2% target at the start of 2025. Core inflation remained virtually flat but is expected to edge up to 3% by the middle of the year on the back of growth in imputed rent due to rising house prices. Inflation will thus remain in the upper half of the tolerance band around the target for the rest of this year. Next year, it will decline very close to the target due to an easing of cost growth. Trade wars and related uncertainty will drag on the economic recovery this year, adversely affecting the trade balance and corporate investment. Economic growth will be driven this year and next year by household consumption expenditure, supported by buoyant real wage growth and a gradual drop in the saving rate. Consistent with the forecast is a decline in short-term interest rates in 2025 Q2. The Bank Board assessed the risks and uncertainties of the outlook for the fulfilment of the inflation target as modestly inflationary overall. The cautious easing keeps monetary policy slightly restrictive, ensuring that the inflation target is achieved even if domestic inflation risks materialise. The trade wars may have both downward and upward effects on inflation. The CNB is ready to react flexibly to the changing economic situation.

Inflation remained elevated in 2025 Q1. In the consumer basket, faster growth in food prices due to rising agricultural commodity prices had an upward effect, whereas lower world oil prices pushed fuel prices down at the pump. Core inflation remained at 2.5%. Within core inflation, however, services prices are still rising substantially faster than goods prices. Buoyant growth in wages and salaries continues to translate into high price growth in labour-intensive service industries.

Inflation will fall towards 2% in April due to a deepening decline in fuel prices and a temporary slowdown in food price inflation. However, it will go up again in the subsequent months, driven by rising food prices and a modest rise in core inflation. This will be connected with growth in the cost of owner-occupied housing, driven mainly by prices of new property. Demand on the housing market has been recovering for a number of quarters now, leading both asking prices and transaction prices of apartments to go up by about 15% year on year in late 2024 and early 2025. According to the baseline scenario, food price inflation and core inflation will remain elevated throughout 2025. They will slow next year and headline inflation will thus return close to the target.

Strong demand persists for new mortgage loans, which in real terms are at levels comparable with historical periods in which the housing market overheated. The price imbalance on the housing market is an upside risk to inflation, due to its possible prolonged duration and potential stronger second-round impacts, as the rising house prices may have a lagged impact on other parts of the consumer basket on top of the forecasted increase in imputed rent.

The tariff policy of the US administration developed very dynamically in early spring. The baseline scenario of the forecast now contains 25% tariffs on steel, aluminium and auto imports into the US and a 10% blanket tariff on other imports into the US. A higher, 25% blanket tariff against the EU has been postponed until early July, as have retaliatory measures.

After the quarterly negotiation period ends, however, there is a danger of the tariff wars escalating further. This could hit the Czech economy through opposing channels. The first is deglobalisation tendencies causing disruptions to current supply chains. Fragmentation of international trade would reduce productivity on a global scale. Restriction of the growth potential of the economy would lead to a need for a more gradual rate reduction than in the baseline scenario.

By contrast, an anti-inflationary effect would be global demand problems caused by higher uncertainty reflected in higher risk premia. The Czech economy would be hit by a slump in foreign trade and related weak investment demand. In this scenario, a depreciation of the koruna and a deeper decline in rates would jointly dampen the anti-inflationary pressures.

According to the baseline scenario of the forecast, the Czech economy will continue to recover gradually. The growth should be driven mainly by household consumption. Following a period of relative caution, domestic households’ shopping appetite increased in late 2024. It will be further supported by a sizeable increase in real wages and a gradual decrease in the saving rate. The increased uncertainty regarding economic developments in the first half of this year is being reflected in a drop in private fixed investment, the shortfall in which is being offset by a positive contribution of government investment and inventories. Concerns about supply chain disruptions are motivating firms to stock up on key production components. The large positive contribution of inventories is also due to a base effect, as previously accumulated inventories were released on a large scale last year. From the end of 2025 onwards, the forecast expects fixed investment to recover on the back of growth in the economic activity of the Czech Republic’s trading partners, a decline in domestic and foreign interest rates, and absorption of EU funds and money from the National Recovery and Resilience Plan.

General government consumption growth will slow this year as extraordinary spending on post-flood reconstruction fades out. Fiscal consolidation will also contribute to this slowdown. Other fiscal measures will have a roughly neutral effect on economic activity. However, the Inflation and Monetary Policy Risks Scoreboard indicates a risk stemming from the wider structural deficit. As shown in Appendix 1, the latter is significantly contributing to money growth and has the potential to create long-term inflation pressures in the domestic economy. The general government deficit is widening slightly over the outlook horizon, driven by higher defence spending. Appendix 2 also shows that general government consumption has also recently tended to be higher.

Goods and services exports will grow only modestly, due to problems in global trade. However, as shown in Box 1, the impacts will only be short-lived. This is because Czech firms seem to have caught the trend of focusing on sectors with bright prospects and on growing markets outside traditional partners in the euro area. As a result, net exports will dampen GDP growth overall this year and next year because of solid growth in import-intensive investment and consumer demand.

The tightness in the labour market is expected to weaken gradually in 2025 and 2026. A modest rise in the unemployment rate this year will be offset by a continued shift of the labour force from industry to services. Given the persisting labour market tightness, wage growth in market sectors will remain elevated this year. This will be joined this year by a larger increase in public sector pay, which may be expanded further.

The exchange rate has been around CZK 25 to the euro since the start of the year. It has been stable despite rising uncertainty connected with the tariff wars. A slightly weaker koruna will be fostered over the forecast horizon by subdued labour productivity growth and a further moderate outflow of investment capital, which will outweigh the current and capital account surplus.

The increase in uncertainty related to the expected weakening of global demand has led to a decrease in cost factors, such as energy commodity prices. The depreciation of the dollar is also a contributing factor. The uncertainty alone is making planning difficult and dragging on investment activity. This is creating room and a need for an additional slight rate decrease despite the persisting strength of domestic demand. Consistent with the forecast is thus a decline in interest rates in 2025 Q2.

The Bank Board assessed the risks and uncertainties of the outlook for the fulfilment of the inflation target as modestly inflationary overall. As regards domestic inflationary risks, the risk of higher-than-expected inertia in services and food inflation persists. Potential additional growth in total public sector spending would lead to a risk of fiscal policy 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 further stronger recovery in lending activity, especially on the property market. Increasing barriers to international trade are a downside risk to global economic activity. However, the impact on inflation is not clear cut, especially in the longer term. The risk of markedly weaker German economic output is partly offset by the planned fiscal stimulus of the new German government.

Chart – Inflation will be in the upper half of the tolerance band around the 2% target this year and very close to it over the monetary policy horizon
headline inflation; y-o-y in %; confidence intervals in colours

Table – The growth of the Czech economy will accelerate this year and remain around 2% next year
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets