The central bank of the Czech Republic raised its benchmark 2-week repo rate by another 25 basis points to 1.75 percent, it’s fifth hike this year, as inflation is seen slightly higher than previously expected due to the recent weakening of the koruna’s exchange rate.
“The overall inflation pressures in the domestic economy remain strong,” said the Czech National Bank (CNB), which has raised its key rate by 125 basis points this year and by 170 points since August last year when rising wages began pushing up inflation amid a booming economy.
In its latest forecast, the CNB sees inflation rising to 2.2 percent by the fourth quarter of next year, up from 2.0 percent previously forecast, before leveling off to 2.1 percent in the final quarter of 2020 – close to the bank’s 2.0 percent target – as the koruna resumes its rise and the growth in wages begins to ease as the economy cools slightly.
Economic growth is seen averaging 3.1 percent this year, slightly down from 3.2 percent previously forecast, but then accelerating to 3.3 percent next year and staying at 3.3 percent in 2020 as household consumption remains buoyant.
The main risk to the CNB’s forecast stems from the koruna’s exchange rate, which has been weaker than expected due to negative sentiment on global financial markets.
This global effect is expected to persist for the next two quarters but the koruna is then expected to rise next year due to the interest rate differential to the euro before its appreciation slows as the European Central Bank (ECB) begins to normalize its monetary policy.
The koruna firmed slightly in response to the CNB’s rate hike to 25.83 to the euro, still slightly below 25.54 at the start of this year. Next year the CNB expects the koruna to firm to an average rate of 24.7 to the euro and then to 24.2 in 2020.
Headline inflation in the Czech Republic eased to 2.3 percent in September from 2.5 percent in August while the economy expanded by an annual 2.4 percent in the second quarter, down from 4.2 percent in the first quarter.
The Czech National Bank issued the following statement:
“At its meeting today, the Bank Board of the Czech National Bank increased the two-week repo rate (2W repo rate) by 25 basis points to 1.75%. At the same time, it increased the Lombard rate to 2.75% and the discount rate to 0.75%. Five members voted in favour of this decision, one member voted for leaving interest rates unchanged and one member voted for raising them by 50 basis points.
The decision adopted by the Bank Board is underpinned by a new macroeconomic forecast of the Czech National Bank. Consistent with the forecast is a continued rise in interest rates towards their long-run neutral level.
According to the external assumptions of the new forecast, the euro area economy will record ongoing growth, but its pace will continue to slow slightly. A weakening of the euro and a distinct rise in energy prices are reflected in rising producer and consumer prices. Euro area inflation will thus be just below 2% over the next two years. This will enable the European Central Bank to end its asset purchase programme at the end of this year. However, it has stated that it will not start increasing interest rates until quite some time later. The 3M EURIBOR is thus expected to remain negative until the end of next year. The oil price rose sharply recently but is expected to decline gradually in the quarters ahead. The market expects the euro to appreciate slightly against the dollar from its current weakened level.
The overall inflation pressures in the domestic economy remain strong. This is due mainly to buoyant wage growth and continued growth of the real economy. At the same time, the inflationary effect of import prices was restored, reflecting growth in foreign prices as well as the weakened koruna. Inflation will increase further early next year. In the subsequent period, however, the inflation pressures will ease owing to growth in interest rates, renewed appreciation of the koruna and a gradual slowdown in wage growth. Inflation will approach the Czech National Bank’s 2% target from above over the monetary policy horizon, i.e. in late 2019 and early 2020. It will then stay at the target during the rest of 2020.
The growth of the Czech economy has slowed. However, it will stay above 3% on average this year and in the following two years. It will continue to be driven mainly by growth in household consumption, reflecting buoyant growth in household income and optimistic expectations. Rising demand and increasingly distinct labour shortages are motivating domestic firms to invest, which is helping to improve labour productivity. Public investment expenditure will also grow further as a result of higher drawdown of EU funds. Fiscal policy will also contribute to domestic demand growth this year and the next via a significant rise in current expenditure. The continued economic growth is reflected in a tight labour market. The unemployment rate is at a record low and there is little room for it to decrease further. This will lead to slower employment growth. Wage growth will remain high, but will moderate gradually.
The exchange rate forecast for the end of this year reflects persisting negative sentiment on global foreign exchange markets. This global effect is expected to partly persist in the next two quarters. However, the koruna will start appreciating again next year, driven by a distinctly positive interest rate differential vis-à-vis the euro area and continued real convergence of the Czech economy. In the following period, the appreciation will slow in connection with the start of monetary policy normalisation by the European Central Bank.
Consistent with the forecast is a continued rise in interest rates towards their long-run neutral level. The rate increase at the close of this year is mainly a response to depreciation of the koruna, which leads to a renewed inflationary effect of import prices. Pronounced inflation pressures from the domestic economy act in the same direction. The subsequent broad stability of rates during next year is a result of the forecasted appreciation of the koruna amid continuing very easy monetary policy in the euro area. A tightening of policy by the European Central Bank will then create room for further gradual growth in domestic rates in 2020.
The overall story of the forecast is essentially unchanged. The biggest change from the previous forecast is later renewal of the appreciation of the koruna. Coupled with higher foreign producer price inflation, it leads to higher import price inflation and subsequently also higher headline inflation. The headline inflation forecast has therefore shifted slightly upwards at the monetary policy horizon. Together with other factors, the weaker koruna leads to a higher interest rate path next year. The prediction for domestic economic growth is virtually unchanged.
The Bank Board assessed the risks to the forecast at the monetary policy horizon as being slightly inflationary. This assessment reflects the risk of a weaker-than-predicted exchange rate, which is connected with a possibly longer duration of negative sentiment on global markets. This could lead to faster and smoother growth in interest rates than in the forecast. Growth in protectionist measures in global trade and the manner of the exit of the United Kingdom from the European Union remain sources of external uncertainty. They have been joined recently by uncertainty related to the approval of Italy’s state budget. The future path of world oil prices, which have recently been very volatile, is also uncertain.”