Dr Zdenek Drabek
Prague, August 1, 2022
Inflation in the Czech Republic has obviously strong elements of cost inflation that originate abroad. Globally high energy and food prices cause inflation, which are the main drivers of those inflationary pressures and cannot be affected by CNB interventions. Similarly, inflationary pressures have been also related to collapsing supply chains in global markets. This is the so-called cost inflation of foreign origin. The anti-inflationary policy of the central bank (CNB), as is the case elsewhere in the world, will of course be ineffective if it tries to dampen those foreign inflationary pressures The only thing the CNB can control is inflationary pressures of domestic origin and thereby ensure that Czech inflation does not exceed that of its competitors.
A critical issue in fighting inflation is the relationship between inflation and economic growth. Stopping Inflation by (completely) strangling the money flow would make the task almost trivial. Aggregate demand would be dampened and with it inflation, but only at the cost of a collapsing economy. The effort must, therefore, be a sensitive approach of monetary policy not only to financial stability but also to economic growth. The economic crisis/recession is the greatest challenge not only for all politicians but also for central bankers. However, this effort is exposed to a constraint, for which economists have found a complicated term – NAIRU (non-accelerating inflation rate of unemployment). In short, this is a rate of inflation and thus a monetary policy that does not lead to an increase in the unemployment rate. And this is, as I argue below, the fundamental Czech problem in current conditions of the labor market, even if it exists in different forms in other countries.
I will use a simplified example of a company producing 1000 cars in two situations before and after an increase in costs and prices of inputs, ceteris paribus. When the company’s costs rise, the company has two options – either to pass on higher costs to its customers (Option A) or to reduce its costs by reducing the number of workers (Option B) to maintain the profitability of its activity. Choice A means that the firm expects an increase in demand for its goods and, therefore, expects an increase in demand in line with the increase in inflation. Choice B means that the firm assumes that it will not be able to pass on higher costs to the final customer and that it does not expect rising inflation.
As the central bank tightens credit conditions and corporate costs rise, the central bank must proceed with caution. It has to demonstrate to the market its “determination” to cool down demand and thus also the company’s expectations, but at the same time it has to do it in a way that will not impede production and will not lead an economic recession. However, the problem for central banks is that inflationary pressures may be created not only by cost pressures from abroad, but also by demand pressures ( and domestically generated cost pressures), which the central bank should be able to control. However, to maintain economic growth while controlling inflationary pressures, the central bank may encounter hard or rigid conditions in the labor market. The labor market may not be able to adapt.
And that leads me to the situation in the Czech labor market. It is characterized by three very hard parameters – high employment, low unemployment rate and high rate of open vacancies, jobs that remain “unfilled”. From a financial point of view, the market is “overheated” largely due to government interventions and those include: (1) the high rate of wage growth in manufacturing and productive services (higher than productivity growth) stimulated by pay increases in the public sector, which took place at the time of collapsing production (supply) caused by Covid and by the disruption of supply chains; (2) Fiscal policy is influenced by rules that act not only as “in-built income stabilizers” such as in the case of pensions, but also as an inflationary factor; (3) generous social supports (4) generous government salary measures for civil servants; (5) the critical role of government wage policy is influencing wages in the private sector (“wage setter”). These and other measures lead to an increase in vacant jobs and a reduction in the labor supply on the market. The main characteristic of this market is that it is strongly shaped by the government’s fiscal spending policy and typically leads to higher inflation under these conditions. As J. di Giovanni of the US Federal Reserve Bank and his colleagues show, inflation is and has been higher in economies that have been exposed to labor shortages in various sectors.
Under these conditions in the labor market, a “soft” monetary policy (interest rates that are supposed to support domestic growth with a positive effect on controlling inflation) in Czech conditions – as they are today – will come into conflict. There will be no growth stimulus because the labor market is already “saturated and thus overheated” – the jobs offered are unattractive in the market and they remain open. The unemployment rate will not fall because there is no “match” between the jobs offered and the unemployed workforce. (e.g., too many art theorists and too few construction workers). Companies will understand that, in this situation, CNB is not putting enough emphasis on suppressing inflation. With the unemployment rate already at an all-time low, firms will not be able to finance their rising costs. There are only two options for firms to take – dismissal of employees (leading to higher unemployment) or fresh labor from abroad (and therefore immigration). Both options are the subject of government policy, and the government must decide which option it want to pursue – tolerating rising unemployment or embarking on new immigration support. In other words, CNB has reached the point of the Czech NAIRU.
Various increases in interest rates were inevitable and correct. The critical question is whether the government will realize and support it with measures that will enable the labor market to function more efficiently. If they want to reduce inflation and hope for economic growth, the government will have to accept new immigrants or put up with higher unemployment.
Dr. Zdenek Drabek is an expert in trade policy and foreign investment. His primary professional aim is to help governments, private sector companies, consumers and civic society at large to understand appraise and decide about the value of trade and investment rules and trade and investment governance. His expertise is driven by his unique background skills, and experience which combine practical experience in top policy advice with deep economic analysis and strong academic origin.