The decision, and the current outlook and its risks

At its February 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 gradual rise in rates from roughly the middle of this year onwards. The rise in rates will be a reaction to inflation stabilising close to the target as the adverse effects of the second wave of the coronavirus pandemic subside thanks to emerging herd immunity. Longer lockdowns at home and abroad and an ensuing further deterioration in the financial situation and sentiment of businesses and households are the main risk to this outlook. This could materialise owing to a potential combination of multiple adverse pandemic factors, including virus mutations and sluggish vaccination.

The second wave of the coronavirus pandemic hit the Czech Republic at full force during the autumn, halting the economy’s promising recovery from the first wave induced by the lifting of epidemiological measures in the summer. The measures were retightened in response to the second wave, first during autumn and then – after a brief easing before Christmas – even more so at the year-end. The Czech government reintroduced shutdowns in retail and services, which affected the domestic economy at the turn of the year. Given the severe course of the pandemic during the winter, the government can be expected to ease the current anti-epidemic measures only cautiously during the first half of the year. The nascent vaccination effort offers a light at the end of the tunnel. The economy can probably be expected to return to normal functioning and mobility and social contact to essentially get back to the pre-pandemic level in 2022, following the expected achievement of herd immunity this summer.

The good news is that growth in the key sector of the economy, industry, which started in the summer, is continuing during the second wave of the pandemic. Industry, foreign trade (including freight transport) and global supply chains have so far proved resilient to the pandemic. This is evidenced by domestic industrial firms’ solid export performance, which is slowing the fall in GDP at the turn of the year. However, the pandemic will continue to weigh on retail, services, recreational, sports and culture activities, and tourism for most of the first half of the year.

The labour market cooling due to last year’s deep downturn is being reflected in a gradual slowdown in fundamental wage growth (i.e. wage growth adjusted for statistical effects) in market sectors. At the year-end, moreover, the decline in employment and the increase in the jobless total continued, despite government programmes to protect jobs in the sectors affected. Overall, fiscal measures markedly slowed the decline of the Czech economy in 2020, mainly by supporting household income and consumption.

After roughly a year, inflation returned to the tolerance band around the CNB’s 2% target in autumn 2020 and fell further in December. This was due mainly to the fade-out of the previously swift growth in food prices and also to lower administered price inflation as a result of cheaper gas and electricity for households. By contrast, core inflation, which had been the driver of headline inflation for the whole of 2020, fell only marginally at the close of the year. Prices at filling stations continued to go down despite the recent rise in global oil prices, which, however, is being offset by a weaker dollar on world markets.

Despite continued government support, the current course of the pandemic is weighing on the sentiment of domestic businesses. Corporate fixed investment will thus be lower in 2021 than last year. Total gross capital formation will therefore switch to modest growth, mainly on the back of continued growth in government investment.

After a slower year-on-year fall in Q1, GDP growth will temporarily shoot up to over 7% in the spring owing to the drop in economic activity during the first wave in 2020. However, the Czech economy will not see truly robust and lasting growth before the summer. As they return to normal life, households will start to partly make up for the previous involuntary deferral of consumption. However, tight family budgets will preclude a rapid return of private consumption to the pre-pandemic level. A continued rise in the jobless total coupled with muted wage growth will dampen growth in households’ income and curb their optimism.

The discontinuation of most fiscal stabilisation measures will have the same effect, despite the extension of existing government compensation schemes and the introduction of new ones. Even the huge tax package fostering a marked decline in labour taxation will fail to reverse the resulting slightly restrictive effect of fiscal policy, as households will save much of the extra income, so this intended short-term stimulus to private consumption will have only a limited effect. By contrast, exports of Czech firms will continue to grow this year on the back of rising external demand and a limited impact of the pandemic on domestic and foreign industry and foreign trade. As anti-epidemic measures are lifted, labour productivity can be expected to rise from mid-2021 onwards thanks to businesses reopening and employees returning to their workplaces. Overall, the domestic economy will thus grow by over 2% this year, despite the initial adverse impacts of the second wave of the pandemic. GDP growth will pick up further next year as household consumption and investment return to steady growth. Together with a positive contribution of government consumption, this will lead to GDP growth of almost 4% in 2022. The Czech economy will thus return to the pre-crisis level in late 2022 and the negative output gap will close. The recovery will also be aided by the CNB’s monetary policy, which has been accommodative for some time now.

Inflation will fall further in early 2021 and will fluctuate around the CNB’s 2% target during the year. Core inflation will slow gradually, reflecting a drop in import prices owing to appreciation of the koruna and low inflation abroad. Subdued domestic fundamental wages and the unwinding of the positive second-round effects of last year’s decrease in VAT (not reflected in prices) will act in the same direction. Fuel prices will record a sharp year-on-year increase in the spring as the drop in oil prices observed last spring fades out, fostering higher inflation. This will later be joined by renewed growth in food prices driven by an upswing in agricultural producer price inflation. A rise in excise duty on tobacco will also put upward pressure on inflation from February onwards. Inflation will thus be slightly above the 2% target in the first half of next year, i.e. over the monetary policy horizon. Monetary policy-relevant inflation, which the central bank focuses on when making decisions, will be slightly lower than headline inflation over the entire outlook due to the above rise in excise duty. Stabilisation of inflation near the target will be supported by monetary policy gradually becoming less accommodative.

Chart – Inflation will return close to the 2% target at the start of this year and will be slightly above the target over the monetary policy horizon
Headline and monetary policy-relevant inflation; in %

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.

Improving financial market sentiment will foster continued firming of the exchange rate. The koruna will also be supported by the reopening of the Czech economy, combined with recovering external demand. The appreciating koruna will also reflect growth in the differential between domestic and euro area interest rates. This is because domestic market interest rates can be expected to rise gradually from roughly the middle of this year onwards, following an initial period of stability. This will reflect the monetary policy response to still appreciable inflation pressures amid a subsiding pandemic, a definitive end to which is now on the horizon thanks to the expected gradual achievement of herd immunity. Rates will continue to rise gradually next year, with inflation anchored at the target and with the prospect of the economy returning to the pre-crisis level.

Tab. – Following a drop last year, domestic economic activity will recover this year and GDP growth will pick up further in 2022
Y-o-y changes in % (unless otherwise indicated); changes compared to previous forecast in brackets