Czech National Bank Preview: No action is the right answer for now

The Czech economy is well positioned to face the current turmoil in the Middle East, with inflation below the central bank’s target, a sound growth structure, and both the fiscal deficit and public debt at manageable levels. The CNB will likely follow the appropriate course at its meeting next Thursday, which is to keep interest rates unchanged at 3.50% until the dust settles.

Czech real industrial production increased by 2.8% year-on-year in January and was down 2.6% from a month ago when adjusted for the number of working days. The reading came in below our forecast, suggesting that industry is not picking up decisively despite its recent stabilisation. That said, the value of new orders grew by 9.8% from the previous year. New orders from abroad gained 8.9% YoY, while new domestic orders added 11.4% annually.

Industrial production has been growing for 12 months in a row, with the largest growth contributors linked to auto production and the metalworking industry in January. The average number of employees in industry decreased by 1.0% YoY in January, while average monthly nominal wage growth eased to 4.7% YoY. Average monthly wage growth in construction slowed to 3.3% in January. Both adjustments align with our expectation of somewhat slower wage growth this year. That said, with inflation likely averaging at 1.7% this year, and nominal wages expected to add some 5.6%, there is still enough growth in real purchasing power to keep the consumer in the driving seat.

Real retail sales gained 5.0% YoY and 1.0% month-on-month in January, beating expectations of market participants. In annual terms, sales of non-food goods increased by 7.8%, fuel added 7.3% and foodstuffs 0.3%. Consumers are better off thanks to lower energy bills and are clearly willing to channel these additional resources into discretionary spending. That said, it remains to be seen how the recent turmoil in the Middle East, along with rising oil and natural gas prices and heightened uncertainty, will affect consumer spending appetite via expectations of higher energy and food prices and weaker confidence.

Taking the latest data on board, we expect inflation to average 1.9% this year, with the core rate reaching 2.7%. Headline inflation will be driven by fuel prices from March onwards, while the second round effects in core inflation will be tangible with a delay.

The Czech economy is in a good position to face the current oil price shock, with the duration of the shock being the critical unknown. Inflation remains below target, while the outlook for economic growth and its structure is still taking shape. One brewing concern is the rising unemployment rate, as the services and construction sectors no longer appear able to absorb further job losses from manufacturing. With all that in mind, the appropriate response to an oil price shock and a negative external supply shock, in general, is to remain calm and keep the base rate unchanged, given the simultaneous risks of higher inflation and weaker economic activity. In some cases, excessive policy activism can do more harm than good.

To be sure, the CNB is well aware of the double-edged sword of a negative external supply shock. Citing Jan Frait: “A sharp rise in energy prices may temporarily increase inflation, but at the same time it can also trigger a global recession. That’s why it’s necessary to keep cool heads in setting interest rates.” The Czech economy enters the current Middle East turmoil from a position of relative strength, with inflation below target, a solid growth structure, and manageable fiscal and debt dynamics.

Food prices also appear well positioned to absorb a considerable oil price shock without causing major disruption. My reading, therefore, is that the CNB’s threshold for resisting a rate hike would require a significantly higher oil price sustained over an extended period - say USD 100/b through September or beyond. It's the change that matters, after all. If anything, I see risks tilted toward a potential cut further out, should the global economy deteriorate sharply. Compared with most economies, the Czech economy currently has a much higher tolerance for today’s shock, leaving the CNB under little immediate pressure.