Economic Analysis - Strong Domestic Economy Warranting More Tightening - 21 AUG 2017

BMI View: The Czech National Bank (CNB) will continue to tighten monetary policy in 2018, after it scrapped its exchange rate floor in April and rais ed rates in August. The Czech labour market is extremely tight , which will continue to put upward pressure on core inflation, while loose credit conditions have led to soaring residential property prices , warranting more tightening measures .

We expect the CNB to tighten monetary policy and raise rates by 100bps to 1.25% in 2018 and by 75bps to 2.00% in 2019, putting us well above Bloomberg consensus. Inflation in the Czech Republic remains on an upward trajectory, with the July reading coming in at 2.5% y-o-y, well above the Czech National Bank (CNB)'s target of 2.0%, while core inflationary pressures are at their strongest in over a decade at 2.6% in the same month. The sustained rebound in inflation has led to the CNB to tighten twice over the past few months. In April, the CNB abandoned its currency floor to the euro, in the anticipation that a stronger koruna (CZK) would result in disinflationary pressures. However, expectations of a hefty CZK appreciation failed to materialise following the free float ( see ' CZK Stability Raises Probability Of Rate Hike' April 7). As a result, a 20bps interest rate hike to 0.25% followed in early August, making it the first central bank in Central and Eastern Europe (CEE) to raise rates since 2012.

Base effects from higher global oil prices will no longer be an important driver of inflation, after being the main driver in the first few months of 2017. Instead, domestic pressures will increasingly be the main driver of price growth, on the back of a strong economic performance. Preliminary real GDP growth in Q217 came in at 2.3% q-o-q and 4.5% y-o-y and we forecast growth to rise sharply to 4.3% for the year and stay elevated at 3.3% in 2018, signalling a major acceleration from 2.4% growth in 2016. Furthermore, economic conditions are set to favour households in 2018-19 and we therefore expect consumer spending to be the main driver of the economy. As a result, we forecast above Bloomberg consensus inflation of 2.7% y-o-y by the end of 2017 and 2.9% in 2018, while averaging 2.4% and 2.8% in those years respectively.

Strong Domestic Economy Sustaining Inflation
Czech Republic - Consumer Price Index, % chg y-o-y
Souce: CNB, BMI

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