The CNB must continue to curb inflation even in an environment of increased uncertainties

At its May meeting, the Bank Board increased the two-week repo rate to 5.75%. The decision is based on the CNB’s spring macroeconomic forecast and responds to the long-term inflation pressures, which are increasing further due to the outbreak of war in Ukraine. Inflation will rise to 15% in the months ahead and remain in double figures for the rest of this year. This will reflect continued growth in gas and electricity prices for households, a further acceleration in food price inflation and persisting high core inflation. Inflation will decline below 10% in early 2023 owing to an easing of the current exceptional price pressures and to the previous tightening of domestic monetary conditions. This will foster a further decrease in inflation, which will fall close to the 2% target in the second half of 2023. Consistent with the baseline scenario of the forecast, in which the central bank sets interest rates in order to achieve the 2% target at the standard monetary policy horizon regardless of the origin of inflation pressures, is a further sharp rise in market interest rates until the middle of this year, followed by a gradual decline from autumn 2022. The Bank Board assessed the uncertainties and risks of the baseline scenario of the spring forecast as being significant and going in both directions. When making its decision, the Bank Board assessed the sources of the currently increasing inflation pressures, which stem largely from strong exogenous price shocks. The Bank Board therefore decided to tighten monetary policy more moderately compared with the baseline scenario of the forecast. It took into account, among other things, the message of a simulation featuring a more distant monetary policy horizon than the standard one used in the CNB’s forecasting system.

The Czech economy is facing a combination of exceptionally strong inflation pressures causing escalating and broad-based price growth. Inflation is hitting new long-term highs in rapid succession. Consumer prices are being pushed up mainly by rising costs of domestic firms. The impact of the cost pressures is being intensified by growth in the profit margins of producers, retailers and service providers. The still solid domestic demand and the persisting good income situation and purchasing power of Czech households is allowing firms to increase their margins.

The upswing in inflation in early 2022 was due primarily to faster growth in administered prices and rising core inflation. Moreover, fuel prices increased wildly at times, as did food prices to a lesser extent. After having surged at the start of this year, administered prices will keep rising apace, owing mainly to continued growth in prices of electricity, gas and heat for households. The increase in energy prices on exchanges to record highs was also fostered by Russia’s invasion of Ukraine. Core inflation will also pick up in the months ahead, driven by strong growth in the cost of commodities and materials, including energy, and with a significant contribution from imputed rent. Continued marked growth in food prices across categories will be caused mainly by rising global agricultural commodity prices, which have also gone up as a result of the war in Ukraine, one of the world’s leading grain exporters. Growth in oil prices, which induced a more than 50% year-on-year increase in fuel prices in March, was also linked with the war. Year-on-year oil price growth will remain high throughout 2022, although it will decline gradually. Further increases in excise duty on tobacco will also foster higher headline inflation this year and the next.

As a result of the above factors, inflation will peak at nearly 15% in late spring and early summer 2022. It will then start to fall as growth in import prices and production costs slackens and the global inflation pressures gradually ease. In addition, the stabilising effect of the previous monetary policy tightening will begin to manifest itself increasingly through domestic demand. Price growth will therefore slow in all segments of the consumer basket in the second half of this year. The statistical effect of last year’s high base will also foster a decline in inflation in late 2022. Inflation will fall back into single figures in early 2023 and return close to the 2% target at the year-end.

For some time now, Czech firms have faced strengthening growth in production costs, driven by global supply chain problems, rising foreign industrial producer prices and a surge in prices of imported inputs. This was joined in the autumn by a sharp rise in energy prices, exacerbated in late February by the adverse economic impacts of Russia’s aggression against Ukraine. However, the strong inflationary effect of import prices is now peaking and the subsequent easing of their growth will start to dampen the rise in total costs in the consumer sector. Their growth will fade rapidly due to a stabilisation and subsequent slight drop in energy prices and a fall in foreign industrial producer price inflation.

The growth in Czech firms’ costs was also due in large measure to domestic factors, which stayed inflationary in early 2022. Wage growth remained more than solid. The Czech labour market cooled only partially during the pandemic and got even tighter after the economy reopened last spring. The unemployment rate edged down further in early 2022, and the steady growth in labour demand came up against labour shortages. Even in such conditions, however, wage growth has not been able to keep pace with the escalating inflation this year. Firms are under pressure from growth in other costs, so there is very limited scope for sharp growth in wages. Real wages will thus drop markedly this year, greatly limiting household consumption, which will essentially stop rising in whole-year terms.

The Czech economy will be hampered throughout 2022 by persisting disruptions to global logistics and supplies of production materials and components, all exacerbated by the war in Ukraine. Domestic fiscal policy will dampen economic growth slightly this year as Covid support programmes are phased out. By contrast, higher government spending on helping Ukrainian refugees and their integration into Czech life will have the opposite effect. Many of the refugees will gradually enter the domestic labour market, contributing to a slight decrease in its tightness.

Economic growth will weaken considerably this year, due to sharply rising prices, slowing external demand growth and worsening general sentiment against the backdrop of the war in Ukraine. The deep decline in real wages will also drag down households’ purchasing power, even though their nominal income will be boosted by further income tax cuts, pension increases and expanded housing-related and other benefits. However, family budgets will be faced with broad and sizeable price growth. Therefore, many households will use the rest of the forced savings they accumulated during the pandemic to maintain their living standards. Spending of income and savings, due to concerns of a loss of purchasing power, will be slowed by continued growth in interest rates and lower consumer appetite. In a similar vein, negative business sentiment and subdued demand will result in a drop in fixed investment, despite continuing efforts by firms to automate and robotise production. By contrast, government investment will rise steadily, supported by absorption of EU funds. Stocks of unfinished products will remain elevated due to global logistics problems. For the same reason, the export performance of the Czech economy will be low until mid-2023. Owing to subdued imports, the contribution of net exports to GDP growth will be slightly positive this year. As the war de-escalates and the problems in global supply chains subside, the contribution of net exports will become much larger. Growth in household consumption and fixed investment will also recover next year. Together with continued solid growth in government consumption, this will lead to an increase in total economic activity of more than 3%.

As a result of this year’s economic slowdown, the current overheating of the domestic economy will fade relatively soon and the labour market will become less tight. Continued forceful monetary policy tightening by the CNB, commenced already in the second half of last year, will also help reduce the domestic cost and demand inflation pressures. Consistent with the baseline scenario of the forecast, in which the central bank continues to set interest rates in order to achieve the 2% target at the standard monetary policy horizon, is a further sharp rise in interest rates. Together with the exchange rate appreciating close to CZK 24 to the euro, this will limit the pass-through of the current exceptional inflation pressures to prices in the longer term and help anchor inflation expectations. As a result, the current double-digit inflation will fall close to the 2% target in the second half of next year. The appreciation of the koruna will be due to a further widening of the interest rate differential vis-à-vis the euro area and a fading of the negative effect of global sentiment after Russia’s attack on Ukraine. Aided by short-term CNB interventions in the foreign exchange market, the koruna soon withstood the war-related depreciation pressure thanks to long-standing solid domestic economic fundamentals and coherent monetary policy. At the end of this year, the koruna will stabilise slightly above CZK 24 to the euro owing to an expected tightening of monetary policy abroad. In a context of receding inflation pressures, and with the prospect of inflation returning close to the target in the second half of 2023, domestic interest rates will be able to start falling gradually from autumn 2022.

The upside risks of the return of inflation to the target outlined above include higher-than-forecasted energy and commodity prices, a threat of inflation expectations becoming unanchored from the CNB’s 2% target and a related risk of higher growth in prices and wages in the medium term. Stronger-than-forecasted negative demand impacts of the war in Ukraine are a downside risk to inflation. The uncertainties include the future course of the war in Ukraine, the future monetary policy stance abroad and the duration of the disruptions to global value chains. 

When making its decision, the Bank Board assessed the sources of the currently increasing inflation pressures, which stem largely from strong exogenous price shocks. The flexibility of inflation targeting also allows the central bank to take into account the current extreme uncertainties surrounding the forecast and adjust its response accordingly.

The Bank Board therefore decided to tighten monetary policy more moderately compared with the baseline scenario of the forecast. In the context of significant risks and uncertainties in both directions, it took into account, among other things, the message of a simulation featuring a more distant monetary policy horizon than the standard one used in the CNB’s forecasting system. This simulation assumes that the central bank abstracts from inflation developments roughly 12–18 months ahead, when inflation remains significantly affected by external price shocks. It also assumes that monetary policy maintains full credibility and inflation expectations remain anchored to the target, thus helping inflation return to the 2% target despite the more restrained monetary policy response. The market interest rate path in this simulation is lower than in the baseline scenario, especially this year. However, inflation in this simulation falls to single-digit levels next year, although the return to the 2% target is postponed until 2024.

Chart – Inflation will climb as high as 15% in Q2 and then start to fall, returning close to the 2% inflation target at the close of next year
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 – Growth in domestic economic activity will slow sharply this year and pick up visibly next year
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets