The decision, and the current outlook and its risks

At its May meeting, the Bank Board kept the two-week repo rate unchanged at 0.25%, in line with the baseline scenario of the CNB’s new macroeconomic forecast. This scenario expects interest rate stability initially, followed by a rise in rates from roughly the middle of this year onwards. A more gradual fading of the pandemic, linked with lengthier lockdowns and a cyclical downturn at home and abroad, which could have anti-inflationary impacts, is a risk to the forecast. A risk in the opposite direction stems from the disruption to global production and supply chains and its pass-through to prices.

The winter wave of the pandemic caused by the spread of the UK strain of the coronavirus in the Czech Republic led the government to extend and further tighten its anti-epidemic measures in February and March. Retail and services stayed closed, resulting in a renewed decline of the domestic economy in Q1. Besides a continued fall in household consumption, the decline was intensified by a partial drop in the production and exports of domestic industry, which until recently had been showing a promising recovery from the first wave. The wobble in industry is due to the temporary disruption of supplies of some commodities, materials and components stemming mainly from currently overloaded global production and transport capacity, which we believe will be short-lived.

Given the still fragile pandemic situation, the Czech government can be expected to be very cautious about easing its anti-epidemic measures. Retail, services, recreational, sports and health activities, and tourism will thus continue to be restricted to varying degrees for much of this year. The initially slow process of vaccination of the Czech population is likely to pick up pace significantly in the months ahead, gradually helping to achieve herd immunity. It can therefore be expected that the economy will gradually return to normal and mobility and social contact will near their pre-pandemic levels.

The labour market cooling due to the ongoing shutdowns of the domestic economy is being reflected in a slowdown in fundamental wage growth (i.e. wage growth adjusted for statistical and one-off effects) in market sectors. The decline in employment and the increase in the jobless total also continued in early 2021, despite ongoing government programmes to protect jobs in the sectors affected.

Inflation fell close to the CNB’s 2% target in 2021 Q1, mainly due to slower growth in food prices, which has been highly volatile recently. Administered prices meanwhile stopped rising amid a continued decrease in electricity prices. Conversely, motorists are probably not too happy about the current rise in fuel prices in reaction to the recent sharp increase in global crude oil prices. Core inflation, which had been the driver of headline inflation for the whole of 2020, remained elevated in Q1. This reflected an only slight opening of the output gap into negative territory last year. Much of the observed decline in the Czech (and foreign) economy was due to a short-term fall in potential output resulting from the shutdowns. Domestic inflation is currently being affected by continued pandemic-related cost pressures from the domestic and foreign economy, showing up mainly as faster growth in industrial producer prices.

Annual GDP growth will temporarily shoot up to 6% in Q2, although mostly due to a low base. The Czech economy will not see truly robust and lasting growth until the anti-epidemic measures are relaxed more significantly during the second half of the year. Economic growth will benefit significantly from renewed strong household consumption, boosted among other things by goods and services purchases involuntarily deferred during the shutdowns. However, households’ optimism will be partly curbed by a continued moderate rise in the jobless total and temporarily subdued wage growth.

The extension of existing government compensation schemes and the introduction of new ones will lead to continued fiscal expansion for most of this year. This is aimed mainly at protecting jobs in the sectors affected and supporting household incomes. To a lesser extent, household consumption will also be stimulated by a reduction in personal income tax introduced at the start of 2021. Next year, however, fiscal policy will turn restrictive due to the discontinuation of government support measures.

Exports of Czech firms will soon return to dynamic growth as the current problems in industry and international trade subside and external demand gradually recovers. Productivity can also be expected to start rising in mid-2021 as the anti-epidemic measures are lifted and the economy reopens.

The very complicated course of the pandemic in the Czech Republic so far and the extremely uncertain outlook for a return of the economy to normal are reflected in negative sentiment among Czech firms. Growth in corporate fixed investment will therefore recover only gradually this year. Total gross fixed capital formation growth will thus turn positive owing mainly to a renewed positive contribution of change in inventories amid continued buoyant growth in government investment.

Overall, Czech economic growth will only slightly exceed 1% owing to the adverse impacts of the pandemic in the first half of this year. Next year, GDP growth will pick up to more than 4%, due mainly to household consumption and investment reverting to steady, robust growth. The domestic economy will thus return to the pre-crisis level in late 2022 and the negative output gap will almost close. The recovery will also be aided by the CNB’s monetary policy, which has been accommodative for some time now.

Inflation will rise close to the upper boundary of the tolerance band around the CNB’s target in the next few quarters. In the months ahead, this will be due mainly to a jump in fuel prices. A rebound in food prices due to growth in world prices of agricultural commodities and domestic agricultural producer prices will have the same effect. The drop in core inflation will be slowed this year by the recent growth in foreign producer prices together with persisting solid domestic demand pressures and the price impacts of the reopening of the economy. A surge in consumer demand as 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.

The fade-out of this year’s high growth in fuel and food prices will help inflation to return gradually to the 2% target next year. Core inflation will also slow further as the supply and demand situation gradually gets back to normal. Monetary policy-relevant inflation, i.e. inflation adjusted for the first-round effects of changes to indirect taxes, will be below headline inflation over the entire forecast horizon owing to a further increase in excise duty on cigarettes. Besides the factors mentioned above, the decline in monetary policy-relevant inflation towards the target over the monetary policy horizon and its subsequent stabilisation will be supported by a gradual tightening of both the exchange rate and interest rate components of the monetary conditions.

The gradual reopening of the Czech economy, coupled with a recovery in external demand and the fade-out of the temporary problems in Czech industry, will foster continued firming of the exchange rate. The appreciating koruna will also reflect growth in the differential between domestic and euro area interest rates, as domestic market interest rates can be expected to rise from roughly the middle of this year onwards following an initial period of stability. This increase will reflect the monetary policy response to still appreciable inflation pressures amid a receding pandemic. Rates will continue to rise next year, with inflation anchored at the target and the economy gradually returning to the pre-crisis level.

Chart – Inflation will rise towards the upper boundary of the tolerance band in the quarters ahead, returning to the 2% target from above 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.

Tab. – Following a drop last year, the domestic economy will return to modest growth in 2021 and pick up more strongly in 2022
y-o-y changes in % (unless otherwise indicated); changes in pp compared to previous forecast in brackets