Czech Republic: Disinflation Challenges Czech National Bank's Rate Cut Plans

Czech Republic: Inflation below 10% is not enough for the Czech National Bank

The economy has confirmed weak activity in recent months, but the numbers are more in line with expectations. At the same time, inflation is surprising to the downside and the overall labour market picture is more anti-inflationary than expected. Looking ahead, the inflation profile looks comfortable – probably the best in the region. We expect June inflation to fall below the 10% YoY threshold and the disinflationary momentum to continue through the summer months. However, disinflation will slow in the autumn and winter, making it challenging for the CNB to cut rates. We expect the first rate cut in November when the central bank will have a new forecast in hand, but we see a risk of delaying a rate cut until the first quarter of next year. This again makes the CNB the most hawkish central bank in the CEE region.

On the fiscal side, we also see a big story. The government recently approved a state budget for next year of CZK235bn targeting 1.8% of GDP, by far the lowest figure in the region. We expect a successful legislative process during the summer months, which implies a reduction of next year's borrowing needs to 60% of this year's level. In addition, June's state budget result showed an improvement for the first time this year.

We thus remain positive on Czech assets. Czech government bonds (CZGBs) should maintain strong demand and we expect the market to shift its focus to supply dynamics soon. The Czech koruna has traded at weaker levels than we expected in recent weeks. However, the koruna should benefit most from the EUR/USD recovery and we see room for a reassessment of market expectations for a CNB rate cut.