Prague, June 30, 2023 (Published in Seznam)
Inflation is still with us and remains a threat to both people’s wallets and political stability. The threat seems to be very serious, so much so that even the “cautious” Bank Board did not set out in the direction of lowering interest rates at its last meeting, and some members of the Bank Board even proposed an increase of 0.25%. In effect, they were confirming what the ECB is now doing, raising its interest rates. A majority of central bankers at a recent meeting in Paris spoke out in favor of continuing the tight monetary policy.
The CNB’s nervousness about inflation is understandable, and there are several reasons for this. Problem No. 1 that the CNB faces is that although there is a consensus among political parties on the need to reduce the fiscal deficit and, if possible, reduce the state debt, the problem lies in the detail of the solution to the budget deficit. The fight over a specific deficit reduction format has been dragging on for months and is still unresolved. And with this, the uncertainty grows.
Problem No. 2 is the damaging impact of inflation. I am not sure is also dominant in the Bank Board deliberations: (1) The real value of pensions is threatened and pension reform, however well-intentioned, may end in a fiasco. Inflation is already having a serious impact on Czech households in several forms: (i) The decline in real household incomes is already a problem accompanying inflation. I expect it to be as high as 18-20% by the end of this year. This means, for example, that households will have to tap into their savings, if they have any, in order to maintain the same standard of living.
(ii) The decline in the real value of people’s savings is the second indisputable victim of inflation. Households that kept their money in bank savings accounts have lost up to 20% of the real value of their savings over the past 18 months. This means, for example, that young people looking for apartments and mortgages will need, ceteris paribus, 20 percent more in cash to make their own contribution to the bank to finance the loan (mortgage) and buy their apartment compared to a year and a half ago.
(iii) The decline in real incomes and savings occurs over an excessively long time period. While a decline in real values in the US for two quarters would be considered the maximum tolerance level, in the Czech Republic this process is already reaching the second year! (iv) People suffer even if they try not to rely on their banks as protectors of the value of their wealth. If they invested their money in investment funds, for example, then they didn’t do much better either. The decline in returns on invested funds in pension funds was around 10-15% in 2022, and even this year’s improved performance does not cover inflation! The incentives to use pension funds, despite state subsidies, are highly inadequate, do not work and, in some years, are even loss-making.
Why dampen inflation expectations ?
The CNB is essentially waiting for inflation to fall “on its own”. It assumes that inflation was driven solely or mostly by rising costs of imported energy and food, not by the inflationary expectations of firms and households (or is it finally recognizing the truth?). This is, of course, a very risky strategy.
The CNB is essentially waiting for inflation to fall “on its own”. It assumes that inflation was driven solely or mostly by rising costs of imported energy and food, not by the inflationary expectations of firms and households (or is it finally recognizing the truth?). This is, of course, a very risky strategy. Inflationary pressure on food and energy prices has fallen, but this may not continue. For example, mortgages rose 17 percent in May, measured against mortgage rates in April – despite increased interest rates. The mortgage market is still below pre-Covid levels but is recovering quickly. Car sales also increased considerably. Flights to Croatia, Spain, Egypt and more tourist destinations are hopelessly sold out. Prague Spring concerts were also sold out, although ticket prices were almost “Swiss”.
So companies are still confident that they can raise their prices if their labor costs rise. The government is still ready to make or identify various compromises that would satisfy the opposition in parliament. And consumers are still willing to spend, even on expensive foreign holidays, even if they have to pay part of it from their savings. Unfortunately, this latter is not true for everyone. Low-income families cannot afford this luxury, and this further widens the income gap.
Any attempt to get rid of inflationary pressures through looser monetary policy is doomed to failure from the start. This is due to a highly tight labor market, where full employment and a large number of unfilled vacancies prevail. The situation on the Czech labor market shadows similar situations in neighboring countries. In Germany, for example, the size of the “work force” today is about 47 million and has stopped growing. The KfW development bank is already warning that the growth potential of the German economy is over.
However, the Czech Republic has its own specifics – a high share of the state in employment. Through its budgetary policy, the state influences wage claims in both the public and private sectors and, of course, the income and demand of households. Looser monetary policy would most likely mean a strengthening of wage demands and growth in domestic demand, thereby strengthening inflationary pressures. A “wage-price” spiral leads to too rapid growth in domestic demand, and companies are able to “withstand” these pressures by raising their prices. Rising wages push inflation up.
The last argument for “tight money” has to do with exchange rate policy. The reasonable stability of the koruna depends on the confidence of foreign investors in the government’s ability to maintain political stability in the country in a situation of almost zero economic growth, restrictive fiscal policy and falling real incomes. It also depends on the CNB’s ability to maintain a reasonable interest rate differential (parity) between the Czech and foreign markets. Given the ECB’s policy of tightening interest rates, the CNB’s countermovement can only lead to a rapid outflow of foreign capital from us.
My last comments concerns the role of fiscal and monetary policy. Some commentators are looking for an optimal mix of both policies. We need to react quickly and push inflation into single digits as quickly as possible. We are in a situation where inflation can be pushed by rising wages, which would only respond to rising prices for goods and services. This vicious circle can only be closed by suppressing inflation expectations.
Prague, June 30, 2023 (Published in Seznam)
Zdenek Drábek