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CNB > FAQ > Exit from the exchange rate commitment

Exit from the exchange rate commitment


Both the public and firms have benefited from the stable exchange rate; why doesn’t the CNB stick with it instead of returning to the now “obsolete” inflation-targeting regime?

Independent monetary policy operating under inflation targeting benefits the Czech economy. This was demonstrated clearly after the global crisis broke out. The just ended exchange rate commitment was not a new CNB monetary policy objective but a temporary instrument used after the room for further interest rate cuts had been exhausted. Price stability – expressed as 2% inflation – remains the CNB’s statutory objective. A (managed) exchange rate float has long been consistent with inflation targeting. The exchange rate often acts a shock absorber in our small open economy. Adjustment through exchange rate movements is smoother and less painful than adjustment through real variables such as employment or wages.

In the long run, the exchange rate reflects economic fundamentals. However, the central bank can use its policy tools to dampen large exchange rate fluctuations that are not consistent with economic developments. We envisage the floating exchange rate regime being applied until the Czech Republic joins the euro area, i.e. until ERM II. Euro adoption is a political decision and cannot be expected in the foreseeable future. ERM II entry was therefore never considered as an option for exiting the exchange rate commitment.

What will the CNB do with the euros it has bought?

The CNB will keep the euros it has bought in its international reserves and will continue to invest them in high-quality, safe instruments. It will not sell the returns on those reserves for the foreseeable future.

How will the interventions affect the CNB’s financial results?

Under Article 98 of the Constitution of the Czech Republic, and in accordance with primary EU law, the primary objective of the Czech National Bank is to maintain price stability. The exchange rate depreciation in 2013–2014 helped to generate a book profit for the CNB, thanks to which the CNB's accumulated book loss has been repaid in full. This, however, was not the purpose of the interventions, as the primary objective of monetary policy, i.e. to maintain price stability, always has priority over the impacts of the CNB's measures on its financial results. In the long run, the CNB's financial results will depend on exchange rate and interest rate developments in the Czech Republic and abroad. The long-run appreciation trend may be renewed after the exit from the regime of using the exchange rate, but at a much lower level than before the crisis.

Is there a risk of a return to some form of exchange rate commitment in the future?

Any strong or sustained anti-inflationary shocks might renew the risk of a sizeable and long-running undershooting of the inflation target or even the threat of deflation in the future. After the room for easing monetary policy by cutting interest rates has been exhausted, this might force the CNB to use the exchange rate as a monetary policy instrument again or to apply another unconventional instrument. However, a return to the exchange rate commitment is highly unlikely in the near future, as inflation is above the CNB’s 2% target in an environment of solid growth of the Czech economy, rising wages and related robust domestic and overall inflation pressures.

The CNB has responded to the current strong inflation pressures by raising its monetary policy rates. Won’t this lead to excessive growth in the cost of loans for households and firms?

Interest rates are the standard instrument the central bank uses to stabilise domestic prices and the domestic economy. At a time when recession and deflation were threatening to occur and the options of the main instrument had been exhausted (monetary policy rates had dropped to technical zero), the CNB was forced to start using the exchange rate as an additional instrument to ease monetary policy. Economic growth enabled it to end the exchange rate commitment and return to the use of interest rates as the standard monetary policy instrument. Raising interest rates is thus a return to normal. Despite the increase at the Bank Board’s meeting in August, interest rates are still well below levels common in the past.

The CNB has boasted about how it helped the economy in past years. By contrast, it is now starting to apply the brakes by raising interest rates. Isn’t this a “brake-and-accelerate” policy?

By its very nature, monetary policy cannot accelerate economic growth and reduce unemployment in the long run. However, it can help curb fluctuations in growth and unemployment. In other words, it can smooth the business cycle. That is exactly what the CNB did in past years. It accelerated growth when the economy was at a low and unemployment was near an all-time high, thus preventing deflation from occurring. Now the still very easy monetary conditions will shift to a neutral stance to prevent the economy and the labour market from overheating. An overheating would lead to inflation staying above the target for a long time and to further macroeconomic and financial imbalances.

Shouldn’t the CNB have held off raising interest rates?

In a situation where the economy is slightly above its potential and inflation is close to the target in a sustainable manner, it is necessary to gradually shift the monetary conditions to a neutral stance. The slight appreciation of the koruna against the euro which we have been observing since the exit from the exchange rate commitment has partly fostered the desired shift of the monetary conditions to normal so far. However, interest rates left at zero would continue to have a strong accommodative effect and could lead the economy and the loan and property markets to overheat undesirably and inflation to overshoot the target even more. The CNB has therefore raised interest rates, which, going forward, should gradually head towards their neutral level. After all, the exit from the exchange rate commitment was conditional on the CNB returning before long to the use of interest rates as its standard instrument.

The koruna has gradually been strengthening since the exit from the exchange rate commitment. How come prices of imported goods (such as electronics, tropical fruit and petrol) and holidays have not fallen, or have fallen much less than the appreciation of the koruna would imply? Were we looking forward in vain to a stronger currency and lower prices?

Importers – just like exporters – may be hedged against exchange rate movements (not only using financial instruments, but also via exchange rate clauses in their contracts, for example). As a result, exchange rate swings may not be reflected proportionately in prices of imported goods, especially in the short term. It will also take some time to sell off the stocks of goods imported while the exchange rate commitment was still in place. In general, it holds true that the decision to reflect exchange rate changes in prices charged to domestic customers is fully in the competence of importers and retailers, who include other cost and demand factors in their calculations on top of purchase prices.

The CNB forecast expects that the current already only slightly inflationary effect of import prices will quickly turn anti-inflationary. This will reflect subdued foreign producer price inflation and the strengthening koruna. Inflation will thus decrease towards the CNB’s 2% target in early 2018 and will be slightly below it over the monetary policy horizon, i.e. in the second half of 2018.

Why is inflation overshooting the inflation target this year?

The overshooting of the inflation target observed so far and forecasted for the rest of this year – inside the upper boundary of the tolerance band around the target – is an expression of the fact that the CNB, in line with its previous communications, exited the exchange rate commitment only when there was a clear prospect of sustainable and robust fulfilment of the inflation target. In this situation, the CNB’s monetary policy can head towards a less accommodative stance. The first step in this process was the exit from the exchange rate commitment. This was followed by the lifting of interest rates from their zero lower bound. The above evolution of monetary variables will show up in inflation with the usual time lag. Next year, inflation will stabilise close to the 2% target.

After more than four years of undershooting, a short-term overshooting of the inflation target cannot be viewed as a problem. Moreover, inflation is being affected by a number of one-off shocks observed in late 2017 and early 2018, which will largely fade away over a time scale of one year. In addition, the room for tightening monetary policy by raising interest rates has no upper bound. The CNB views its target symmetrically and will therefore be ready to raise rates in order to keep inflation close to the target if inflationary shocks hit the economy.