Peter Laca (Bloomberg, 12.6.2012)
Anti-inflationary risks are prevailing in the Czech economy because of declining demand even as a weaker koruna eases monetary conditions, central bank board member Lubomir Lizal said.
Policy makers in Prague are assessing the impact of the government’s tax increases on inflation and the effects of the euro area’s sovereign debt crisis on the economy, which is in a recession. The central bank’s board split three ways over monetary-policy settings at the last meeting on May 3 as members saw diverging inflation risks.
Lizal was among the four board members voting in May to keep the benchmark two-week repurchase rate unchanged at a record low of 0.75 percent. Two policy makers, including Governor Miroslav Singer, sought a quarter-point cut in the main rate, while one rate setter wanted an increase to 1 percent.
“The economy is performing worse than expected, while the overall situation has led to a weaker koruna,” Lizal said in an interview at his Prague office yesterday. “The latest forecast assumed a decline in interest rates, but it also assumed an exchange rate at a different, stronger level.”
The Czech economy contracted in the final quarter of 2011 and in the first three months of this year as weakening domestic demand outweighed rising exports after households cut spending.
Price growth has exceeded the central bank’s 2 percent target for eight months as the government increased the sales tax to boost budget revenue.
Weaker Koruna
Gross domestic product in the January-March period fell 0.8 percent from the previous three months, after a 0.2 percent decline in the fourth quarter of 2011. Retail sales fell 4.1 percent in April, the biggest decline in two years, while the manufacturing PMI fell to the lowest in 33 months in May.
The koruna has lost 2.7 percent to the euro since May 2, one day before the central bank released its forecast that signaled a decline in interest rates this year. It was 0.4 percent weaker at 25.651 to the euro as of 10:05 a.m. in Prague.
“Since the current forecast was published, we have seen lower GDP data, inflation that was more or less in line with expectations and quite a significant weakening of the koruna, which is easing monetary conditions,” said Lizal. “Still, I would consider the risks to the forecast to be rather on the anti-inflationary side at this moment, mainly because of the weak demand in the domestic economy.”
Balancing Act
Central banks across Europe are weighing the effects of the sovereign-debt crisis with slowing growth and the need to narrow budget deficits. The European Central Bank and Poland both left interest rates on hold on June 6, while Hungary held the European Union’s highest benchmark rate at 7 percent for a fifth month on May 29.
The Czech May inflation rate dropped to 3.2 percent, the lowest this year, from 3.5 percent in April. The rate was 0.2 percentage points lower than the central bank forecast. Inflation relevant for monetary policy, defined as price growth adjusted for the primary impact of changes in indirect taxes, eased to 2 percent in May, matching the bank’s target.
The central bank forecasts inflation will slow to 1.5 percent in the second quarter of next year. Headline inflation may exceed the bank’s forecast if the government pushes through another set of measures aimed at boosting the budget revenue, including an additional increase in the sales tax.
Tax Changes
“I assume there will be another change in the tax rates, mainly the value-added tax, which will preserve the difference between headline inflation and monetary-policy inflation next year,” Lizal said. “What I consider important is how this higher inflation affects wage negotiations.”
First-quarter GDP data support Vice Governor Vladimir Tomsik’s view that interest rates should be lower, he said on June 8. The economy’s weak performance is increasing chances that rates will be cut rather than raised, Vice Governor Mojmir Hampl, who voted for stable rates last month, was quoted as saying on May 15.
Board member Eva Zamrazilova has demanded a rate increase for two sessions, while Kamil Janacek said he maintains his view that rates shouldn’t be cut further.
For Lizal, the koruna’s moves may be a crucial factor when deciding on interest rates as a weaker currency is loosening monetary conditions by making exports cheaper. The koruna has been affected by the general market mood tied to developments in the European debt crisis, he said.
“Investors have a tendency to view any European assets as less credible, and sentiment now seems to be skewed toward a koruna weakening rather than appreciation,” said Lizal. “The GDP data were also a negative signal, and will probably be a factor keeping the exchange rate at levels weaker than assumed in our forecast.”
Lizal was commenting euro-area debt crisis, domestic economy and monetary policy in an interview:
On the euro-area crisis:
“The basic expectation is that we will probably see several years of muddling through. This means a path of small, gradual steps which may be needed to avert a catastrophe, but aren’t enough to bring a fundamental solution to the crisis.
‘‘Whatever steps we see now, they are still not reversing the pessimistic market sentiment. Even if there is a good measure, it’s not enough to change the market mood.
‘‘I’m skeptical we will see some internal impulse that would change this. I’m afraid the only factor that could turn market sentiment around would have to come from outside, for instance a sudden acceleration in global economic growth.”
On regulation:
“We see a potential risk in proposals leading toward pan- European regulation of the financial sector, as under these circumstances banks would be assessed as a whole group on the European level.
‘‘This would mean domestic regulators will have fewer options to affect undesired behavior of such groups toward a well-capitalized, or, even worse, undercapitalized, subsidiary that the domestic regulator is responsible for.
‘‘In Europe, the general tendency at the time of crises seems to be to invent new regulations, rather than to first analyze whether the existing rules are sufficient, and whether the authorities didn’t fail in imposing them.’’
On the Czech economy:
‘‘The effects visible now are mainly through sentiment, rather than through real economic links. While exports are performing well, domestic demand is less than weak and expectations aren’t too bright either.
‘‘This means companies don’t see reasons for any massive investments, which then reinforces negative sentiment.
‘‘The Czech mentality is to try to prepare for the negative possibilities rather than for the more optimistic ones. At the time of negative news, a typical reaction is to be even more cautious, to be prepared for even worse situation.
On the economic outlook:
‘‘The first-quarter GDP reading was significantly worse than we thought. The 0.7 percent annual decline was quite a negative surprise.
‘‘I assume there will be another change in the tax rates, mainly the value-added tax, which will preserve the difference between the headline inflation and the monetary-policy inflation next year. What I consider important is how this higher inflation affects wage negotiations.
‘‘That will be a reflection of inflation expectations, whether there has been a shift upwards, or whether people are aware that the current situation shouldn’t spark higher wage demands.
‘‘Since the current forecast was published, we have seen lower GDP data, inflation that was more-or-less in line with expectations, and quite a significant weakening of the koruna, which is easing monetary conditions.
‘‘The economy is performing worse than expected, while the overall situation has led to a weaker koruna. The latest forecast assumed a decline in interest rates, but it also assumed an exchange rate at a different (stronger) level.
‘‘That said, the exchange rate may be volatile, and move in either direction relatively quickly.
‘‘What will be important for my decision is to analyze the effects of these two factors.
‘‘The exchange rate is affected by general market mood and the situation in Europe. Investors have a tendency to view any European assets as less credible, and the sentiment now seems to be skewed toward koruna weakening rather than appreciation.’’
‘‘The GDP data were also a negative signal, and will probably be a factor keeping the exchange rate at levels weaker than assumed in our forecast.
‘‘Still, I would consider the risks to the forecast to be rather on the anti-inflationary side at this moment, mainly because of the weak demand in the domestic economy.’’
On fiscal policies:
‘‘In a small and open economy, the government doesn’t really have any options on how to change the trends in the economy quickly.
‘‘Today, in Europe, we are paying the price for past policies, for fiscal deficits from years of economic growth. This is now limiting the room for governments to allow deficits to grow and smooth the economic cycle in years of recession.’’