CNB preview: Easing story comes to an end

Our outlook for Czechia's economic performance received a non-negligible boost recently, with real GDP growth lifted to 2.4% for this year (from 2.1%) and to 2.7% for next year (from 2.5%). This year’s change is mainly driven by the revision in 2024, carrying a more upbeat performance towards the year-end. The change for next year reflects discussions and plans for additional defence spending, which will benefit Czech industry and the economic performance. Our current growth forecast is thus 0.4 and 0.3 percentage points above the latest Czech National Bank Winter projection for this year and next. Two pistons are driving the recovery right now: robust consumer performance and a revitalised construction sector.

The annual wage growth of a robust 7.2% at year-end came in above the CNB's expectations of 7%, while real wage gains were higher than market participants had foreseen. Annual real retail trade was softer than expected at the beginning of the year. However, this is largely due to base effects, as the pattern was exactly the opposite in December and January in previous readings. We don't think the retail sales deceleration is particularly noteworthy, as the yearly growth rate is influenced by distortions. We conclude that Czech households have enough financial muscle to support the economy with their spending.

The labour market has softened somewhat as layoffs in industry kick in, but this has not yet significantly impacted the strong wage growth. Moreover, the construction sector has partially compensated for these job losses, and should industry hit bottom in the near future, as we believe, the scarcity of labour could again become one of the main bottlenecks for further economic expansion, without generating inflationary pressures.

And here we approach the soft spot of any central banker’s heart: inflation will likely not drift back to the target. It will likely hover in the upper tier of the tolerance band, hitting the limit here and there over the course of this year, and will remain above the target well beyond. We see inflation averaging at 2.7% this year and remaining at 2.4% next, which is 0.3 percentage points above the latest CNB forecast. When plugging in all the available predictors, our best guess about the nearest headline inflation reading in March is a stable 2.7% annually, with a marginally softer core rate and more potent food price growth.

That said, we see a punchier inflation outlook given the stronger domestic currency compared to the latest CNB projection. Indeed, the Czech economy is positioned for an accelerating expansion, supported by consumer spending, a rebound in construction, and likely the bottoming out of manufacturing. Such growth will likely halt the recent easing in the labour market and add heat to broad-based inflationary pressures over the coming quarters. These jigsaw pieces compound the story of renewed convergence to the more advanced eurozone economies regarding prices, wages, and real growth performance. In turn, the growth outperformance vis-a-vis the eurozone will support the koruna against the euro over the coming quarters.

With the Czech economic rebound gaining traction, the current leitmotif of monetary policy easing comes to an end. We believe the bank board is in a general position to get the easing job done, proclaiming an agreed nominal rate as an equilibrium or natural rate, and looking ahead to what comes next. Our output gap estimate suggests that it would come into a neutral position early next year, along with a gradual recovery of the potential growth. Once the output gap turns positive, the economy should start to see general shortages in production inputs for the given output level, resulting in a situation much more favourable to broad-based price pressures across economic segments than seen before. We see a parallel situation in 2017, as the economy decisively entered a phase of overheating, and interest rate hikes followed suit in August.

Should the base case of an economic rebound prove right, we expect broad inflationary pressures to intensify from mid-2026 onward. There are other supporting elements for this outcome stemming from the political domain, such as the EUR 500bn defence and infrastructure fund agreed in Germany, including some relaxation of the debt brake. There is also a critical consensus across the Czech political spectrum that defence spending should be increased, perhaps to some 3% of GDP. The CNB has indicated that it sees extra fiscal expansion as a clear risk to consumer price growth.

The Czech industrial base has a lot on offer in the arms industry, so the overall Europe-wide propensity to spend more on defence would provide an additional boost to the Czech economic performance, which is already, to some extent, reflected in our more upbeat projection. The shift from manufacturing cars to producing weapons, following Europe's awakening after three years of intense conflict, is likely to benefit Czech economic performance in the coming years.

Manufacturing, the backbone of the Czech economy, has not been doing well for a long time, which manifests itself in stagnant industrial production from 2018 onwards, and flat investment activity for the last two-and-a-half years. This situation may change soon, as we believe that Czech industry has overcome the worst of its challenges, which is confirmed by the latest confidence survey. Business confidence in the economy increased in March across all sectors, with industry picking up to 94.8 points, the highest level observed since last October.

However, there is a serious threat of a vicious cycle when an economy fails to attract investment, struggles to retain it, and ultimately faces disinvestment. Such is the case with Germany, Czechia’s most important trading partner, where fixed investment has been trending downwards since 2019 and is now at roughly the same level as in 2016. To enhance labour productivity, all the extra fiscal spending planned across Europe must be used efficiently and directed towards fruitful sectors.

Nevertheless, this is not guaranteed and must be realised in practice, as labour productivity has long been overlooked in European efforts. However, we see a viable path for the Czech economy to thrive, driven by four key factors: sustained household consumption, a rebounding construction sector, a bottoming out of industry and investment, and the resurgence of strong export performance.

The labour productivity quandary remains an open wound. When taking a broad perspective and some degree of simplification, we see that Czech and German productivity amelioration has broadly kept pace with the US for a long time. We see periods when one had outperformed the other, benefitting from the German advanced machinery edge or driven by the intensive internet and ICT development in the US. However, something obviously changed around 2019, when the labour productivity gains stalled in Germany and were wiped out for the Czech economy only two years later.

Also, things still can go wrong for industry, as there are many structural hurdles on the European scale, such as the high price of the emission allowances resulting in prohibitively high energy prices. Mounting administrative costs and regulatory red tape that firms in Europe face are also not helping in the context of fierce global competition, with European competitiveness under pressure for a long time. One also has to admit that there is quite some uncertainty about dealing with such difficulties when looking ahead.

The hurdles to investment appetite and improved productivity represent a key issue for European economies, as labour productivity gains allow for higher consumption of better-quality goods and services at a manageable increase in the overall price level. This is a crucial element when determining where the CNB should set the policy rate for the next year or so. The stronger the economic expansion, the higher the likelihood of additional price pressures. Given the persistent tightness in the labour market, a policy rate of 3.5% is worth considering.

From a strategic standpoint regarding future communication, it is essential to demonstrate that every effort was made to help the economy reach its potential after several wasted years. Hence, we echo Cato the Elder: Ceterum censeo Carthaginem esse delendam. Setting the base rate at 3.25% this summer is the preferred option, providing a more favourable starting position for the next phase. This target is likely to be achieved through rate reductions in May and August, when a comprehensive CNB forecast is available.