CNB rate stability after November - between the koruna and post-election reality
Comment by Jaromír Šindel, Chief Economist of the CBA: The stronger koruna, lower inflation, and the return of productivity growth give the central bank some relief, allowing it to monitor how wages and the post-election fiscal plans—often pulling in opposite directions—will play out.
On Thursday, 6 November, the CNB Bank Board will probably not want to differ from the ECB's decision and will leave interest rates unchanged, i.e. the two-week repo rate at 3.50%. The CNB's communication is also likely to remain unchanged, i.e. the future trajectory of the interest rate could go in any direction, but most likely leaving the interest rate unchanged will be motivated by the need to maintain tight monetary conditions and thus insure a return of inflation to the target. The details of GDP and wage growth released at the end of November, together with clearer contours of the new government policy, may lead the CNB to possibly change its communication. The CNB is likely to make only cosmetic adjustments to the GDP growth outlook of around 2.5% next year, with a gradual convergence towards the inflation target, although probably still above 2%.
The hawkish pressures, which in previous months were supported by stronger wage growth in Q2, will be dampened in the central bank's communication by a more pronounced slowdown in September inflation to 2.3% yoy, albeit mostly driven by lower food prices. A stronger koruna of more than 2% compared to the central bank's expected EURCZK 24.9 for the final quarter of this year adds a further "cooling" effect.The stronger koruna in last two, three months not only reflects the difference between Czech and euro interest rates, but also the effects of US monetary policy and stock market developments (see chart below).Stronger economic growth in Q3 will reinforce the CNB's need to maintain tighter monetary policy settings.
For the time being, however, stronger GDP growth would have a rather milder impact on the Bank's communication because of the unknown strength of wage dynamics with respect to rising productivity and the unknown composition of productivity growth. The latter may change the interpretation of disinflationary pressures induced by a stronger crown. I am thinking in particular of improved industrial sentiment, which - if it led to higher growth in industrial activity - would dampen some of the disinflationary pressures from the koruna. In this case, the latter would also reflect better real industrial fundamentals. However, this scenario is undermined by the weaker purchasing managers' index in manufacturing. Overall, however, sentiment indicators do not point to a decline in industrial production, also thanks to the better level of German export expectations (see lower charts). However, the weaker Czech PMI is a reminder of the continued negative role of demand weakening industrial prospects with negative implications for investment (see link above).
The CNB's communication will later be influenced by the new government's economic plans, from two perspectives - how the government's actions on administered prices will dampen inflationary dynamics and how fiscal policy will in turn intensify inflationary pressures in the economy, or the government's borrowing needs, which may affect the risk premium and the exchange rate of the koruna. However, the CNB will react only to the specific formulation of measures rather than to the programme statement itself.
The contradictory implications of the government's statement for the CNB are reflected in the following:
1️⃣ The effects of the government's actions on inflation and price expectations, both in the area of energy and administered prices:
- E.g. consumer-paid RES cancellation: in October 2022, the temporary RES waiver had a consumer price impact of 0.4% points),
- the return of the 75% discount on student and senior fares: in 2022, the reduction of the discount to 50% resulted in savings of just under CZK 2 billion and the additional 25% discount effectively represents a 50% price reduction, which, given the weight of students and pensioners in the transport segment in the CPI basket of around one fifth, could have an impact of around -0.1% points )
- lower VAT (e.g. on prescribed medicines and catering)
However, in addition to the direct disinflationary effect on prices, there will also be an income effect through higher household disposable income. In the medium term, structural reforms, e.g. acceleration of the construction procedure with the potential for a more favourable supply side on the property market) can also be included among the disinflationary factors.
2️⃣ How new fiscal policy will affect inflation through:
- Public sector wage growth (e.g. 50k starting salaries in the police would be about 20% above the average after training, in education about 6% above the industry average),
- financial support for housing (down payments or subsidies on mortgage interest, although here the impact is limited to the age of 6 years of the child),
- tax credits for school fees,
- the introduction of EET/ERS 2.0 (in December 2016, prices in the catering sector rose by 3% m/m).
3️⃣ Failure to kick-start stronger economic growth may result in higher borrowing needs of the state, with possible negative effects on the risk premium and the exchange rate of the koruna (here, however, we are talking about the relative impact of, for example, vs. faster implementation of the German fiscal stimulus or France in fiscal trouble).
There may also be negative effects from additional fiscal challenges that undo important aspects of the pension reform, for which the Budget Council has estimated (p. 29) positive impacts of up to 0.6% of GDP per year over a 10-year horizon and up to 2% over a 30-year horizon and beyond, or that will further narrow the room for manoeuvre of fiscal policy, which has increasingly been subject to the phenomenon of policy valorisation over the past decade (i.e. the growing share of valorisation schemes instead of political decision-making). In detail, this includes, for example, the capping of the retirement age, higher valorisation of pensions, but also of the salaries of soldiers and prison guards.
Although the future government refers to the balanced economy of 2016-2019, growth then was not driven by structural changes, but by demand stimulus and faster wage growth compared to productivity, which created a future, i.e. recent, inflationary breeding ground.
The stronger koruna reflects not only the difference between Czech and euro interest rates, but also the impact of US monetary policy and stock market developments
The koruna poses a greater disinflationary risk in Q4 so far, while we don't know the wage data for Q3 yet, then Q2 significantly exceeded the CNB's prediction, even in the case of unit labour costs (here Q3 GDP data give hope thanks to stronger productivity)
Overall, however, sentiment indicators do not suggest a decline in industrial production ...
... , also thanks to better German export expectations
