The Czech National Bank (CNB) decided to further increase interest rates at its September meeting. The key two-week repo rate rose by 75bp, from 0.75% to 1.50%, which exceeded the market expectation of a 50bp hike. The central bank has not taken such a step since January 1998, when it began targeting inflation. It has always increased rates gradually and never by more than 25bp. An increase in the repo rate by 75bp was supported by five of the seven bank board members. The other two monetary policy interest rates also rose, with the discount rate up from 0.05% to 0.50% and the Lombard rate from 1.75% to 2.50%. Therefore, the standard interest rate band of 1pp on both sides of the key repo rate was restored.
The main reason for the rapid rise in interest rates is the central bank’s concern about rising inflation. It reached 4.1% yoy in August, double the CNB’s target and marking the highest level since November 2008. Core inflation even rose to a historical high of 4.8% yoy, with widespread price increases, especially in services. We forecast that inflation will continue to rise for the rest of the year. We expect it to reach 5.4% yoy at end-2021, but there is a risk of an even higher rate. At the press conference, Governor Rusnok also admitted that inflation is likely to further increase by the end of the year.
The significant increase in interest rates being perceived as non-standard is actually good for the central bank, as it needs to send a strong signal that it is ready to fight inflation. The inflation expectations of households and firms have increased recently, and the associated concerns about price increases are already reflected in lower confidence in the economy. In addition, monetary policy has not materially tightened so far. Although the CNB raised interest rates by a total of 50bp in June and August, inflation rose by a full percentage point during that time. Thus, real interest rates paradoxically have been lower than at the beginning of the year.
In our view, the tightening of Czech monetary policy is likely to continue for the rest of the year. We expect a repo rate of 2.00% at its end. Governor Rusnok said that the pace of further rate increases will depend on new data coming from the economy, as well as what the CNB’s November forecast will show. The last CNB forecast from August did not anticipate such a rapid rise in consumer prices, as August inflation was a full percentage point higher than the central bank expected. It seems that the CNB is ready to increase interest rates almost as quickly as it cut them in 1H20.
The risk of higher inflation does not only apply to this year, but also to 2022. It is still unclear how long current supply-side bottlenecks will persist, especially in the event of another COVID wave. The increase in the prices of building materials is also beginning to have a sizable effect on the costs of owner-occupied housing (imputed rents). Moreover, we are likely to see a significant rise in energy prices at the turn of the year, with the tight labour market likely influencing prices as well. Lastly, we note that Czech fiscal policy continues to be very accommodative.
As the CNB is expected to raise interest rates significantly this year, we forecast only two more 25bp hikes in the first half of 2022, with the repo rate reaching 2.50% at end-2022. This is close to the level that the central bank considers to be monetary policy neutral.
Economic and Strategy Research
26th September 2022
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26th September 2022