CNB preview: Stubborn inflation keeps rate cuts on ice

The Czech National Bank board made clear over recent months that the cutting cycle was coming to an end. As Governor Ales Michl put it: “We don’t have an agreement for now whether this was the last cut or not. What we do agree on is that the room for lowering rates further is limited and that further cuts are preconditioned by a decline in inflationary risks in the domestic economy.” Well, that’s it, folks. The recent domestic data indicates more upward price pressures in the pipeline for the Czech economy, which are tangible in all sectors except industry. Moreover, foreign price pressures have gained fundamental momentum, whether due to already higher global oil prices linked to the recent escalation of the Middle Eastern crisis or the increased risk of disruption to global supply chains.

Taking into account the recent data and developments, we foresee faster price growth in almost all components of the consumer basket, whether it be fuel and food prices on the one hand, or services prices and imputed rents on the other, implying more potent core inflation. The labour market remains tight, wage growth lofty, and real retail sales are flying high. Nominal wage growth was only a tick below the CNB's expectations in the first quarter, yet monthly data and the booming residential sector suggest that a meaningful deceleration is likely not in sight. With all this on the table, we see no further rate reductions as our base case scenario.

That said, industry’s underwhelming performance and lukewarm fixed investment remain an open wound. Still, the CNB’s mandate is to maintain price stability, so the accumulated inflation risks take the upper hand in the decision function. The no-further-cuts take represents a shift in our assessment, with a cut in the summer remaining rather a theoretical possibility should the Board give more weight to the soft industrial data. Meanwhile, we expect headline inflation to rise to 2.9% and core inflation to 3% in June, similarly to the CNB. The upward risks stem from potentially stronger food and services prices, while the downward risk is linked to regulated prices, given the uncertainty surrounding the impact of announced electricity and gas price reductions by major distributors.

A pressing issue for the rate-setters is the increasing distortion in the residential market. Realised prices of second-hand flats gained 15.8% annually in the first quarter of the year, when looking at the Republic’s average, and this dynamic has strengthened since end-2023. The property market is running hot across virtually all metrics: demand exceeding supply, savings flowing into the market, households taking mortgages, the increasing number and value of purchases, more building permits, the construction sector upswing, and residential prices accelerating. These directly impact the imputed rents, which account for 10.3% of the CPI consumer basket and make up almost a fifth of core inflation.

As the property price dynamic gains prominence, we have developed an alternative equation in our projection model that includes residential prices directly. The concern is that the statistics on property prices are available only on a quarterly basis and are published with a significant lag behind the CPI. We have only recently received the 1Q imputed rents observation, while inflation is already being estimated for June. This represents at least a three-month lag compared to an optimal situation where the explanatory variable is available on the spot, or better, with a one-month lead. To project the imputed rents, we also utilised the prices of construction work as a viable regressor, as these are ultimately reflected in property prices and the cost of housing.

The assumption about property price dynamics is broadly based on the previous two residential booms, with the quarterly gains reaching roughly 80% of what we observed during the 3Q 2020 to 2Q 2022 episode overall, while reaching some 70% on the forecast horizon starting in 2Q 2025. So, the assumption might be seen as an upper-bound scenario with continued gains in residential prices, yet it is not too much of a stretch and remains well within the margin of realistic outcomes. The implication is that annual imputed rent growth will further increase, up to more than 8% in March next year, with core inflation gradually picking up to almost 4.5% a month later.

Further momentum in the residential market would have repercussions for the base rates setup, as the imbalances would ultimately become an issue in the monetary policy domain via more upbeat consumer inflation. Meanwhile, the CNB has not recently taken the opportunity to adjust the macroprudential levers, with the mortgage lending rules and the level of capital reserves to cover cyclical and systemic risks remaining unchanged. It is a matter of fact that such tools should be used solely for macroprudential purposes by law. That said, financial stability is not a concern right now, as Czech banks remain well-capitalised. Nevertheless, the further acceleration in property prices represents an unpleasant impetus for rents and core inflation that has to be taken seriously.

The swift price increases of agricultural producers represent another inflationary channel, as these gained 15.7% annually in May, despite some relief in the pricing of seasonal items such as vegetables. Still, the upward price trend in animal products remained unabated. There is, in any case, enough price pressure to make food more expensive for consumers over the coming months. This might even be exacerbated by the recent surge in Brent crude prices and the generally elevated uncertainty about supply chain conditions in times of amplified geopolitical tensions. Add the continued persistence in service prices, where the disinflationary process seems to be on hold, and the tight labour market, which implies solid wage growth amid a continued economic rebound, and you must conclude that this is no country for old doves.