Czech inflation – currently the highest in the European Union (EU) – is likely to remain above the central bank’s target for most of this year, limiting the room for deeper rate cuts to boost the country’s feeble growth, according to Pavel Sobisek, chief economist of UniCredit’s Czech subsidiary.

The Czech economy has been blighted by stagflation since the COVID-19 pandemic. As well as the highest inflation – which hit 17.5% last January – Czechia remains the laggard of the EU as the economy has still not recovered to its pre-pandemic level. GDP grew just 0.2% quarter on quarter (q/q) in the fourth quarter and declined 0.2% year-on-year (y/y) and 0.4% over the whole year.

Sobisek – who has been chief economist of UniCredit and its predecessor bank since 1995 – told bne IntelliNews in an interview that the Czech National Bank (CNB) is set to continue cutting rates at its next monetary board meeting on February 8, after beginning its easing cycle last month in the first change since June 2022.

“The CNB is clear that it is willing to go down quite rapidly in the first half of this year,” he says, predicting a cut of 25bp or 50bp, after a cut of 25bp to 6.75% last month. “50bp would do no harm in my view.”

However, Sobisek is “less sanguine” than the CNB about inflation in the second half of the year. He says the CNB expects inflation will reach its long-term target of 2% in the second half this year, but he is more cautious, predicting around 3% at the end of the year.

Inflation in December was 6.9% y/y, and the overall average in 2023 was 10.7%. The Ministry of Finance forecasts average inflation of 3.1% this year, the CNB 2.6%.

“Later in the year we may get secondary shocks and this is obviously not in the model of the CNB itself,” he says. “If this happens it is a reason to stop cutting rates earlier than the CNB expects.”

The International Monetary Fund (IMF) concurs. In its forecast in November, the IMF forecasts that inflation would be 2.9% at the end of the year and only reach the CNB target in early 2025. It recommended that the bank keep a tight policy stance.

“Risks are tilted to the downside for activity and to the upside for inflation,” it reported. “Staff recommends keeping the policy stance tight for some time to ensure inflation returns to target in a timely manner and to reduce the risk of an upward shift in inflation expectations.”

Sobisek currently predicts the CNB's key rate will only fall to 4.5% by the end of the year.

CNB Governor Ales Michl has been criticised by many economists both for not raising rates higher after he took over in the summer of 2022, when energy costs soared after Russia’s invasion of Ukraine in February 2022, and also for not bringing them down sooner last year. But Sobisek defends the bank.

“With the benefit of hindsight, not raising rates above the level of 7% was just about right,” he argues, given that inflation was largely dependent on external factors that the bank couldn’t influence.

“I think the CNB could have started to cut rates a bit earlier, perhaps November rather than December,” he adds, but says this was not very significant.

On the edge of recession

High inflation and interest rates have hurt consumer spending and businesses, keeping the economy either in or on the edge of recession last year.

Workers have suffered eight quarters of decline in real wages – another worst record in the EU – though Sobisek argues this has helped to counterbalance the “too fast” growth in 2016-19 and improved competitiveness. “Real wages declining in the last two years just puts them in long-term balance,” he says.

As inflation eases and interest rates come down, growth this year looks slightly better: The finance ministry, CNB and IMF predict growth of just 1.2%, while UniCredit forecasts 1.5%.

Businesses are still cautious – forward-looking purchasing manager indices (PMIs) remain negative and have been so for a year and a half – but consumer confidence figures released last week showed signs of improvement, with the indicator increasing by 5.8 points to 91.2.

The finance ministry forecasts that wages should increase by 6.6% y/y this year, enabling real wages (after inflation is taken into account) to grow by 3.2% after two years of decline. Even so, this year real wages will not yet return to pre-pandemic levels, constraining consumption.

At the same time, little support can be expected from other components of GDP, such as investment and exports, given the recession in Germany – the destination of a third of Czech exports – and the uncertain global geopolitical outlook, which could further strain supply chains.

EU money from the Recovery and Resilience Facility should help but may not have a full impact until 2025. Meanwhile, government spending will have a negative impact, following the centre-right government’s austerity cuts of CZK100bn last year, which the finance ministry predicts will depress GDP by 0.5pp.

The cuts are designed to reduce the budget deficit from 3.6% of GDP last year to a forecast 2.2% this year, which will keep Czechia from falling foul of the EU’s Excessive Deficit Procedure – the only larger Central European economy to manage that.

UniCredit predicts a 2.8% deficit, which would still be under the 3% threshold and would allow the very unpopular government a little space to stimulate the economy in the 2025 election year.

“The government has used the window of opportunity and most of the impacts will occur at the start of this year, which is still well ahead of the parliamentary election,” says Sobisek. “Next year there should be no more budget austerity. “It should not affect the general public.”

“The size [of the package] is in my view appropriate, both in terms of the purchasing power of households and it should have a measurable impact on the bottom line [of the public finances].”

The government has been criticised for failing to protect living standards from the impact of food inflation and soaring energy prices – a major reason for the high inflation rate and its unpopularity– but Sobisek commends it for biting the bullet by cutting energy subsidies.

“This needed to stop,” he says. “It was a bit painful but now the energy situation is such that there are no energy skeletons in the closet, unlike Slovakia or Poland.”

Slow-growth dynamic

What worries the veteran UniCredit chief economist is that there has been “too much focus on this one step”.

“The economy is losing competitiveness,” he says. “If you concentrate too much on the fiscal component, you will lose time for boosting the competitiveness of the economy.”

The Czech economy – the richest among the CEE member states – has been stuck in a slow-growth dynamic since the pandemic and now  “long-term sluggish growth is the main risk”, he says. GDP per capita on a purchasing power basis was 90% of the EU average in 2022, but last year convergence went backwards and it will only make modest progress this year.

“Real convergence has stopped since 2019 or even gone in reverse. I don’t see convergence coming back in the next few years,” he warns. “In order to make a leap ahead there would have to be new impulses and I don’t see what that would be.”

The government’s economic advisory body last week issued 37 recommendations to boost growth, which will now be considered by the cabinet.

Sobisek jokes that the National Economic Council (NERV) makes the same recommendations every year, but he agrees that if some of them were finally enacted they would help.

“We need small intelligent steps to boost potential growth in five years time,” he says. “If half of them were adopted by the end of the election term it would be a huge success.”

One of the biggest problems is the shortage of labour, which will become worse because of demographic shifts. Unemployment is the lowest in the EU at an average of 2.6% in 2023 and companies and potential foreign investors often complain of a shortage of staff.

“Low unemployment is becoming a bigger problem than high unemployment,” Sobisek says. “Czechia has reached a systemic low point of unemployment some years ago and cannot go lower.”

“Why should companies come to the country if they can’t get a labour force?” he asks.

NERV recommends a set of measures to raise the workforce, including easing the procedures for bringing qualified workers from abroad, and lowering the number of Czechs trapped in never-ending personal debt collection procedures so they can move out of the black economy.