By rejecting higher rates, the CNB is sending a signal to everyone – go and spend!
Are the Czechs having a ball? Do they have any financial concerns? Judging by the reaction of the central bank (CNB) and the speeches of the members of the monetary board (with a few exceptions), there is, as it were, “peace on all fronts”. At the same time, today the Czechs are facing one of the worst economic situations in the last 30 years. The Czech economy is in recession and without growth, which seriously threatens their wallets but also what the state can reasonably do for those who need help or for social services. In addition, the Czech economy is going through an inflationary period which also threatens social peace and political stability. Cost of living increases and is more and more painful for those who fall more and more into absolute poverty and it affects the recently acquired prosperity. SMEs are suffering and under enormous pressure to finance their operations at today’s high interest rates. The real value of savings is dropping dramatically. We are the country with the highest rate of inflation in Europe, perhaps only rivaled by Hungary and Latvia. One can refer to such important deterrent examples as Turkey, Argentina, and Pakistan, where inflation is rampant even more. At the same time, CNB is waiting and will calmly announce to the public that it estimates a reduction in the inflation rate only at the end of this year.
In the meantime, the current fiscal policy continues to generate the inflationary pressures. To the teachers, the government is promising to raise their salaries to the level of 130% of the average salary. This could not go unnoticed by the management of Czech universities, who are now pushing for an adequate improvement in the financial rewards of their employees. Companies respond to these wage pressures by regularly increasing the prices of their products or services – optimistically expecting that the market will absorb these wage increases. So far, they have not been wrong. The state is increasing real spending on the military, which is understandable given its international commitments and the war in Ukraine, but, on a general level, a clear articulation and explanation of the priorities of the public investment program is missing. Touching the budget expenditures of ministries has proven to be a highly politically sensitive task. As a result, budget expenditures are growing dramatically, and it already seems more than likely that the projected budget deficit will be greatly exceeded. At least, that’s what the two former finance ministers argue(Kalousek and Schillerova) as well as the former CNB governor Rusnok or former president V. Klaus.
There is probably a perception in CNB that inflation will decrease over time without its additional intervention and that it will be painless. The latter is difficult – the budget will not allow it this year, and the state, as an important employer, plays a key role in the labor market. Energy and food prices, which play a key role in determining our inflation, are mainly formed on global markets and therefore outside the control of CNB. Although energy prices are no longer at the same levels as 6-8 months ago, they remain well above pre-Covid and Ukraine war levels. The prices of food and many other intermediate products are often determined by prices influenced by global transport chains. What is even more important is that the exchange rate of the Czech koruna, which is celebrated by CNB as an important monetary anchor, is not nearly as successful and effective as an anti-inflation policy tool as CNB apparently hopes and argues. Basically, it does not work at all as an inflation buffer and if it works it does so only marginally. Examples are the above-mentioned prices of imported food and/or the prices of foreign services for Czech households and companies (see, for example, the prices of holidays in Egyptian resorts near the Red Sea). All in all, market expectations are still very pro-inflationary and driving inflation.
The only institution that can change inflation expectations, and in our case limit or completely eliminate inflationary expectations, is the central bank and, therefore, the CNB. The CNB cannot order the government or the minister to spend money, but it can force the government to be more frugal by further raising interest rates. The higher these rates of interests are, the higher the state’s debt service and the less room for budget financing of other social and investment needs. By rejecting higher rates, as the new CNB governor A. Michl did when he took office, he only sent a signal to the government – you have time to spend (and to waste). Likewise, the CNB failed to moderate the inflow of short-term capital from abroad, which takes advantage of the high nominal interest rates on the Czech banking market and the CNB’s declared love for maintaining a stable exchange rate of the Czech koruna. This policy greatly and further worsens the competitiveness of the Czech economy, which is a separate problem that I will return to in my next comment.
There is another reason why CNB should act as soon as possible. Inflationary expectations are strongly shaped by fiscal policy, as I have indicated, which means that fiscal policy as well as other structural policies addressing the various failings of our market will also play a critical role in moderating our inflation. However, one of the big problems and shortcomings of fiscal policy is its relative rigidity and time-consuming nature. The fiscal’s anti-inflationary measures must not only be identified, but also discussed in the parties and then in parliament, which will undoubtedly require a relatively long time. Unlike fiscal policy, monetary policy can be decided from week to week and the impact of changed interest rates on the market is almost immediate.
In the past, I dealt with problems of inflationary expectations in other countries, mainly in the so-called “emerging economies” around the world. Critics may argue that the Czech Republic is not comparable to these countries. This is possible, but it is extremely interesting that these countries are also not at all like each other. What transpired from those experiments around the world is a finding that in all countries burdened with high inflation, one policy worked in the same way in all of them – a bold approach of central banks to eliminate inflationary expectations. Monetary policy will not solve all the ills of the market, but it is crucial in this situation.
Prague, April 25, 2023
Dr. Zdenek Drabek