The CNB cautiously lowers interest rates, inflation will gradually decrease towards the 2% target

At its February meeting, the Bank Board lowered the two-week repo rate by 0.25 pp to 3.75%. Inflation fell significantly to close to the central bank’s 2% target last year. Price stability was thus restored in the Czech Republic. However, inflation went up temporarily at the close of the year, owing mainly to a year-on-year rise in food prices. That the increase in the price level is temporary is indicated by flat core inflation, which is adjusted for volatile consumer basket items. It stayed only slightly above 2%, reflecting subdued demand and cost pressures in the domestic economy. Inflation will fall in early 2025 owing to lower growth in administered prices. It will be very close to the 2% target over the monetary policy horizon. The recovery in economic activity will gain momentum this year and the next. This will be aided by renewed investment growth and accelerating household consumption supported by rapid real wage growth. Consistent with the baseline scenario of the winter forecast is a continued decline in short-term market interest rates, followed by broadly stable rates from mid-2025 onwards. The currently still slightly restrictive monetary policy stance will ensure that inflation is anchored to the target. A modestly inflationary overall assessment of the risks and uncertainties of the outlook is the reason for a slower decrease in domestic interest rates compared with the baseline scenario.

Inflation was very close to the CNB’s 2% target for most of last year. However, it has risen in recent months, due an increase in food prices. Annual inflation reached 3% at the year-end, despite a month-on-month decrease in the price level. The December inflation figure was affected by a lower comparison base in December 2023, when retailers incorporated a decrease in VAT on food into prices in advance. This effect was not repeated last year. The stabilisation of core inflation at low levels, reflecting subdued domestic demand and tight monetary policy, is important. Within core inflation, however, services prices are still rising substantially faster than goods prices.

Inflation will go down at the start of this year. This will be due mainly to electricity prices for households, where a decrease in the commodity component will outweigh a slight increase in distribution fees. Fuel prices will continue to decline year on year in 2025. By contrast, food prices are likely to rise in Q1 due to the previous increase in agricultural commodity prices. However, their growth should weaken gradually over the rest of the year, owing to fading cost pressures and firms’ falling profit margins.

Czech households currently remain sensitive to inflation. This is evidenced by their still elevated inflation expectations, which should fall as inflation declines. In an environment of rising domestic demand, however, this assumption is fragile and subject to the risk that profit margins will not fall at the pace expected in the forecast. The scenario of elevated margins in the services sector has therefore been updated and now includes persisting higher cost pressures from food commodities. The scenario implies tighter monetary policy compared to the baseline scenario throughout this year.

Continued price disequilibrium on the housing market is another risk to the forecast. For many months now, this market has been associated with elevated volumes of new mortgages, comparable in real terms to pre-Covid levels. At that time, property prices rose at double-digit rates. This can be retrospectively assessed as an overheating of the housing market. However, widespread expectations of further property price growth coupled with interest rate cuts may lead to excessive money creation, generating economic imbalances and fostering a long-term underlying inflationary environment.

After tentative growth last year, the Czech economy is on track to a continued recovery. However, it will remain below its potential. In addition to household consumption, renewed growth in investment (both inventories and fixed capital) will drive the economy. This is due to expected growth in the economic activity of the Czech Republic’s trading partners, a gradual decline in domestic and foreign interest rates, and absorption of EU funds and money from the National Recovery and Resilience Plan.

Households were relatively cautious last year. This was reflected in fragile consumer confidence and a saving rate well above the usual long-term level. As indicated in Appendix 2, the increase in effective taxation due to the government’s consolidation package last year significantly dampened growth in the real net wage, which nonetheless reached the pre-Covid level. This year, households’ shopping appetite will increase because of growth in disposable income, especially wages. Less attractive interest rates on deposits are inducing households to gradually reduce their elevated savings. This is causing growth in private consumption to outpace growth in people’s income.

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. The Inflation and Monetary Policy Risks Scoreboard continues to indicate an increased risk stemming from the wide structural deficit, which is contributing to growth in the money supply. This has the potential to create long-term inflation pressures in the domestic economy. The general government deficit is hardly decreasing in size at all over the outlook horizon.

Germany is still facing economic headwinds that are hindering the recovery of the euro area as a whole. However, this adverse effect has recently been offset by growth in Czech exports to non-euro area countries. This is discussed in detail in Box 1. Aggregate external demand will thus pick up due to rising exports to markets outside the euro area. However, net exports will dampen GDP growth overall this year because of strong growth in import-intensive investment and consumer demand. The persisting risk of a protracted downturn abroad has been taken into account in a scenario of slower economic growth in the euro area combined with the above-mentioned scenario of higher domestic inflation. For the domestic economy, this combination of factors means markedly slower GDP growth over the forecast horizon and higher inflation this year. Compared with the baseline scenario, this implies somewhat higher rates initially and a sharper decline in rates next year.

The labour market remains tight. Throughout 2024, the unemployment rate held steady at one of the lowest levels in the EU. It is expected to rise modestly during 2025 due to the lagged impact of the previous downturn in domestic economic activity. For some time now, growth in unemployment has been dampened by a transfer of labour from industry, which has been hit by a drop in demand, to market services. Given the persisting labour market tightness, wage growth in market services will remain elevated this year. This will be joined this year by an increase in public sector pay.

The exchange rate has been close to CZK 25.2 to the euro since the start of the year. It is expected to weaken slightly from mid-2025 onwards due to subdued growth in labour productivity and a lower trade surplus. Its longer-term outlook is around CZK 25.3 to the euro.

The overall assessment of the macroeconomic situation makes it possible to ease monetary policy further. Consistent with the baseline scenario of the winter forecast, therefore, is a continued decline in short-term market interest rates, followed by broadly stable rates from mid-2025 onwards. Monetary policy will thus move from slightly restrictive at the start of this year to broadly neutral over the rest of the outlook.

The Bank Board assessed the risks and uncertainties of the outlook for the fulfilment of the inflation target as modestly inflationary overall. Higher-than-expected inertia in services and food inflation is an inflationary risk. Potential additional growth in total public sector spending would lead to a risk of the state budget 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 significant recovery in lending activity, especially on the property market. By contrast, a downturn in global economic activity and weaker German – and hence Czech – economic output are a significant downside risk to inflation. Some large central banks have already responded to this risk by lowering monetary policy rates and indicating their readiness to continue easing monetary conditions this year. The impact of some of the actions by the newly elected US administration represents a source of uncertainty for prices.

Chart – Inflation will be slightly above 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 Czech economy returned to growth last year and will accelerate further this year
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets