Czech and Slovak inflation – currently amongst the highest in the European Union – are nearing their peak but will remain far above their central banks’ targets next year.
This may mean that interest rates will have to stay higher for longer and that more fiscal tightening will be needed, two leading Czech and Slovak central bank board members told a webinar organised by the Joint Vienna Institute (JVI) training centre on December 12.
“We can’t do much about inflation in the short run but it can feed into inflationary expectations and affect the credibility of central banks,” Ludovit Odor, deputy governor of the Slovak National Bank (SNB) told the webinar.
On December 15 the Czech National Bank (CNB) and the European Central Bank (ECB), which sets Slovak interest rates, will hold meetings, with the CNB expected to again keep rates at 7%, while the ECB is widely predicted to increase its key rate by at least 0.5 percentage points to 2 per cent.
Central Europe is suffering some of the highest inflation rates in the European Union, at levels not seen since the late 1990s. Headline inflation is currently around 15-20% y/y, compared to 5-10% in other regions, partly due to the preponderance of food prices in the inflation basket (it represents 50% of the Slovak one, according to Odor).
Moreover, soaring energy price rises have yet to be fully translated into consumer prices, with Slovakia and Hungary for example only due to uprate their household energy prices early next year.
Secondary effects from the supply side shocks, as well as rising inflationary expectations, will also continue to keep inflation high.
Czech consumer prices fell from 18% in September – a three-decade high – to 15.1% in October but rose to 16.2% in November, amid volatility caused by the government’s schemes to moderate energy price rises. The central bank said inflation would have been 3.6 percentage points higher – close to 20% – without the government schemes.
Tomas Holub, a member of the CNB board, told the webinar that “most probably we have passed the peak of core inflation”, at 13.8% in November, with momentum now slowing.
He said he expected headline inflation to decline in early 2023 but added that it would only get close to the central bank’s target of 2% in the first half of 2024. Governor Ales Michl said in November that inflation is expected to be “around 20% at the end of the year”, and added that the CNB expects inflation to “drop to 2% within a year and a half”.
Most local analysts expect a decline in Czech inflation only in the second quarter. In its autumn forecast, the European Commission predicted that inflation would peak in 4Q2022 at levels close to 20%, and then average 9.5% in 2023.
In Slovakia, inflation hit 15.4% in November, the highest for 22 years. The European Commission has forecast inflation to average 13.9% in 2023 after averaging 11.5% in 2022.
Slovakia’s membership of the Eurozone means it has less tools to fight inflation, because it cannot push the exchange rate higher to moderate rises in consumer prices, nor set its own policy rate.
Odor said stubbornly high core inflation in the Eurozone was likely to make the ECB keep raising rates.
“We are very close to peak inflation in the Eurozone but I expect core inflation to be a bit stubborn in the next few quarters, so I expect more increases in interest rates [from the ECB],” the SNB vice-governor told the webinar.
Awaiting the first rate cut
All local Central European central banks have now halted interest rate rises but none has yet begun to cut its policy rate.
Dutch bank ING said in a research note on December 12 that the likely rise in inflation to close to 19% around the end of the year could mean that the CNB delays cutting rates till later in 2023. “We do, however, see a risk of a slower inclination to discuss rate cuts next year compared to our forecast, which currently expects the first rate cut in the second quarter of 2023."
UK-based economic consultancy Capital Economics said in a research note on December 7 that it expects headline inflation in Central and Eastern Europe (CEE) to peak at around 20% in the next few months, but to fall sharply next year to single digits by the end of the year.
It predicts inflation to be low enough and the inflation outlook improved sufficiently by mid-2023 for CEE central banks to start cutting rates, but the easing of core price pressures may thereafter be more gradual, so that interest cuts are protracted.
“[…] Given the stickiness of core inflation thereafter, we do not expect headline inflation to fall back to central banks’ targets until around 2025 at the earliest. That’s ultimately why we think that policymakers will be slower than most expect to bring interest rates back to neutral levels.”
Holub pointed out that the Czech economy – and particularly the labour market – was already overheating before the spike in energy and food prices linked to supply problems after the Russian invasion of Ukraine. “The combination of very loose monetary and fiscal policy has contributed to the inflation spike,” he said.
“We will aim for low single digits [inflation] in 2024 but I’m not convinced it is enough to reach 2%,” Holub said.
The Czech central bank first hiked interest rates in June 2021, along with Hungary the first central bank in the region to do so. But Holub argued that “we should have started hiking even earlier” and he has continued to press for further rises since the rates were put on hold at 7% this June.
He cited the recommendation of the International Monetary Fund in its report last month: “The risk of inflation expectations becoming untethered or wage-price spirals forming —against the backdrop of already high inflation and an easing but still tight labor market—are high.”
“While a careful tread between high inflation and weakening economic activity is needed, priority should be given to decisively quelling inflation. Staff recommends further hikes to the policy rate in the short term, to bring down high inflation and to ensure fulfillment of the inflation target over the medium term, while reducing the risk of inflation expectations becoming untethered,” the IMF said.
The IMF warned that inflationary expectations are above the inflation target, and nominal wage growth, though below inflation, has continued increasing. It said depreciation pressures on the koruna could arise if the interest rate differential versus major central banks narrows as they tighten their monetary policies.
Czechs shun further rate rises
However, CNB Governor Ales Michl has opposed further rate rises since he took his first monetary policy meeting in June, arguing that it will hurt economic activity. He has instead preferred to prop up the crown through market interventions to moderate inflation.
Soaring inflation will also reduce real wages, thereby compressing household consumption, which up to now has been the main driver of growth in the recovery from the COVID-19 pandemic. Unlike its neighbours, household consumption is already falling in the Czech Republic.
In November the CNB lowered its GDP growth forecast from 2.3% to 2.2% for this year and for next year it expects a 0.7% drop as opposed to the 1.1% growth that it forecasted in August. For its part, the Czech finance ministry predicted in November that the economy will grow by 2.4 percent this year and decline by 0.2 percent next year.
In its autumn forecast, the European Commission predicted minimal GDP growth of 2.5% this year and 0.1% in 2023, while the IMF predicts 2.3 percent in 2022 and a recession of around -0.5 percent in 2023.
For Slovakia, the European Commission forecasts growth of 1.9% in 2022, and then 0.5% growth in 2023, though the Slovak central bank predicts a 1% recession that year.
Given that rises in interest rates only begin to affect demand after about a year, Michl has argued that there is a danger that the CNB could overreact to the current price pressures.
The majority of the Czech central bank, moreover, sees the inflationary impulses as being largely external supply side pressures, which local interest rates can hardly affect. For his part, Holub estimated that three fifths of inflation was foreign-based, while Odor said in Slovakia it represented two thirds.
Furthermore, in both Czechia and Slovakia there are as yet no clear signs of a wage-price spiral, with real wages in the Czech Republic falling the fastest in the EU at 9.8% y/y in the third quarter.
Nevetheless, Holub points out that a nominal 8-9% wage growth would not be consistent with the CNB’s 2% target, and he expressed concern that unions could become impatient with continually falling real wages. “If we can show unions we are keeping inflation below 10%, we can moderate pay rises,” Holub said.
Both Odor and Holub therefore argue for fiscal policy to take up more of the strain, given the limitations and risks of monetary policy, but had little confidence that their governments would oblige at a time when citizens are struggling to cope with the cost of living crisis.
“If we have 7-8% inflation for two to three years we really need help from fiscal policy to control expectations,” Odor told the webcast, before conceding, “I don’t see from what sources the disinflation pressures will come.”
For his part Holub said, “In the Czech Republic I wouldn’t put much hope on fiscal policy. The political situation is not favourable for this to happen.”
Prime Minister Petr Fiala's centre-right government has only pledged to bring the overall public finance deficit below the 3% of gross domestic product EU target by the end of its term in 2025.
According to the latest European Commission forecasts, the Czech budget deficit will continue to decrease from 5.1% of GDP in 2021 to a projected 4.3% in 2022 and 4.1% in 2023, while Slovakia’s deficit will decrease to 4.2% of GDP in 2022 but then rise to 5.8% of GDP in 2023, because of the later implementation of the government’s measures to alleviate the crisis.