Martin Slaný: Inflation in the Czech Republic has no chance to fall below 2% in the near future

Why is inflation unlikely to fall below 2% anytime soon? This and much more will be discussed in today's exclusive interview with economist Martin Slany.

This time, I've brought in Martin Slany, Chief Economist at DRFG and lecturer at the University of Economics in Prague, to talk to him about the current events surrounding inflation.

I'd like to talk to you about the outlook for 2023. Recently, the CBA published its macroeconomic outlook and I'd like to get your opinion. Specifically, your view on whether we will finally see inflation fall to single digits?

Almost certainly this year, but whether headline average inflation will also be in single digits this year is a question. More importantly, however, is when inflation will return to values that correspond, or rather corresponded before the inflationary period, to long-term inflation - i.e. to values around 2%.

''Under the current conditions, especially in view of the labour market and the dismal state of public finances, the inflation target will not be achieved for a long time. Inflation will be in single digits, but higher than 2%. And I am concerned that the economy will not quickly adjust to this new normal - or that inflation expectations will be anchored at higher levels.''

Generally speaking, what do you think has caused such drastically high inflation in the Czech Republic?

There were exogenous, external factors. These were the triggers, but they would not have ignited the problem if the economy had not accumulated earlier internal problems, largely caused by unfortunate policies - the green transition policy, quantitative easing, the exchange rate commitment, the zero interest rate policy, and last but not least the covid and post-covid policy of compensating everything and everyone. This has accumulated large macroeconomic imbalances. The impulse may be from the supply side or the demand side, but inflation is always demand driven.

What will actually be the main thing that could finally tame inflation and bring it down to single digits?

''The fundamental conditions of the Czech economy today do not allow inflation in the Czech Republic to fall back to 2% in the foreseeable future.''

For this to happen, it is conditional on two fundamental factors: the government starts to make a really substantial fiscal consolidation of spending and transfers, and the labour market goes through a cleansing treatment and the effects on it are not fiscally neutralised. Or option three, the central bank will put the brakes on even more, curbing demand in the economy even more, but de facto at the cost of a secondary and much more painful recession.

Do you think the labour market will be significantly affected this year?

I don't think so. The economy is in a recession, but some early data already suggest that it will be only mild. The labour market is not overly sensitive to the current economic slowdown. After four years, we are returning from a completely abnormal situation, which, moreover, only illustrates the overheating of the labour market, when there was an excess of vacancies over the number of people in the job centres. The situation was reversed in January, but unemployment remains very low. It will rise over the course of the year, but only minimally; quantitatively, it will be a movement similar to that during the covado, in my view. This does not mean that the recession will not have more significant effects in some sub-markets, in regions.

The new CBA forecast looks like this: → continued economic contraction in 1Q23, full-year stagnation → acceleration of inflation above 10% in 23, decline to 3% in 24.

What do you think? Do you see it similarly? Alternatively, I wonder why this will be the case?

At this point, probably the correct answer is that I don't know. At least for the time being. GDP decline, I guess, but I wouldn't be so optimistic about inflation. There may be a really sharp slowdown in household consumption, pushing down domestic inflation, and in aggregate demand this effect may be partly offset by foreign demand and a recovery in investment. But as I said above, given the speed of budget consolidation and the labour market, the forecast seems to me rather optimistic, especially in the speed of the decline in inflation.

''But I stress, the decline in inflation is a very fundamental thing. Inflation is an economic evil, it destroys the economy and it is also very anti-social. Let pensioners be an example. They may have had their pensions over-valorised until recently and seem to be the winners of the situation, but they are also the group that is now enjoying their accumulated wealth and inflation is eating into their life savings (unless they have done something active with them in terms of investment) and limiting their future consumption.''

The Czech National Bank (CNB) at its meeting on 2 February 2023 left interest rates at their current levels, i.e. the two-week repo rate at 7%, the discount rate at 6% and the Lombard rate at 8%. Do you think this is a good strategy or would it have been better if they had proceeded with an increase?

''First of all, the monetary policy transmission, the effect of changing rates into inflation, is ongoing. Normally 12-18 months, maybe even longer in today's economy. Or the CNB may be fighting inflation now, but that's in 2024.''

And the question is how strongly the effects of the already hiked rates from last year will be felt in the meantime. They are clearly having an effect, but we don't know how strong the ultimate effect will be. Of course, economic developments - both domestic and external - are spontaneously reacting to this. For example, the koruna is significantly stronger than estimates. This is not an insignificant factor in an open economy. And the stronger exchange rate, together with rates, is also causing overall monetary conditions to tighten considerably. Whether enough to bring inflation back to target quickly remains to be seen. As I said, fiscal policy and the labour market are pushing significantly against this.

Monetary policy is not just about blindly following models, as I get the impression from some comments. It is also, after all, policy, not an exercise in applied macroeconomics in some artificial laboratory world. Further tightening of monetary policy has real implications for everyone's wealth, and of course no one wants to step on the brake any more than necessary. On the other hand, the risk of anchoring higher inflation is there.

Personally, after the summer pause last year, I would have raised rates even more sharply in the autumn. A more effective solution for the economy, and for the continued effectiveness of monetary policy, seems to me to be a more vigorous but shorter rate rise rather than a smaller but all the more prolonged period of high rates.

The Czech economy has officially entered recession, with gross domestic product falling for the second consecutive quarter in the fourth quarter. But analysts say the drop should be mild and the economy will soon return to growth. How do you see it?

I basically agree, but the question is what is the next growth. In my opinion, it is more likely to be a kind of stalling in place. When the external influences subside completely, the domestic factors that will negatively affect further developments will rather increase.

I saw in one of your interviews that you mentioned that in order for inflation to fall, the deficit needs to be reduced. How can such a deficit be reduced?

Well, of course, there are two ways - higher taxes and/or lower spending. I am in favour of the latter. Firstly, because the problem with the budget is spending, especially of a mandated nature. And the second factor is that tax increases may have short-term fiscal effects, but may negatively affect long-term growth.

And how to cut spending? Broadly. Once you get bogged down in picking off sub-items, the vast majority will never materialize. There will be enormous pressure from various interest groups. And there will also be great social tension and a sense of injustice as to why the government is favouring one group or another. If the budget is in the situation it is in, the state simply cannot afford to provide the same, or much more, services than in the past. So I really do believe that across-the-board cuts - from freezing salaries and pensions for a period of time, which, in fact, have risen unprecedentedly recently, to cutting publicly provided services - are sustainable in the long term.

How can we effectively defend ourselves in this challenging environment, or how can we not let inflation ''eat'' our money? Do you have any specific tips?

''It's a good idea to start defending yourself if you haven't already. With 2% inflation, the average person hasn't had to deal with investments much, largely just saving. But if inflation is 15%, 10 this year, and the question is what happens next, then if one doesn't want to lose a significant amount of wealth, one needs to actively invest.''

High inflation, on the other hand, can make such decisions too hasty. It is certainly not a question of succumbing to the panic that now I have to catch up with the previous inflation with yield. That would be very risky.

For a first-time investor, it is advisable to start with a more conservative instrument, such as mutual funds, which are strictly regulated. And it's up to each client to decide what kind of fund to invest in and whether it's in line with their preferences and view of risk. For conservative Czechs, real estate funds seem to be suitable. And once they try it, let them move on.

I would certainly be wary of any miracle get rich scheme, and that's if any investment vehicle has a significantly higher yield than the competition. In most cases this is offset by significantly higher risk.

  • Did you enjoy today's interview? If so, be sure to follow us, today's exclusive guest was Martin Slany.

Please note that this is not financial advice. Every investment must go through a thorough analysis.

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