CNB issues Inflation Report IV/2013

• The baseline scenario of the forecast implies a significant decline in market interest rates well below zero. This cannot occur in practice, so the forecast points to a need to ease monetary policy further using instruments other than interest rates
• Following the decision of the CNB Bank Board to use the exchange rate as an additional instrument to ease the monetary conditions, the alternative scenario taking into account the launch of interventions becomes the most likely description of expected future economic developments
• The alternative scenario quantifies the impact of a weakening of the exchange rate close to CZK 27/EUR on the expected evolution of the domestic economy. Inflation will return towards the target as early as 2014 H2 and GDP will grow faster in 2014 compared to the baseline scenario. The probability and robustness of the expected exit from zero monetary policy interest rates in the longer term also increases

At its meeting on 14 November 2013, the Bank Board of the Czech National Bank approved this year’s fourth Inflation Report. The Report is one of the core elements of the central bank’s communication with the public in the inflation-targeting regime. An important part of the Inflation Report is a description of the CNB’s quarterly macroeconomic forecast. The forecast is a key input for monetary policy decision-making. The inflation forecast and the assumptions underlying it are published with the aim of making monetary policy as transparent, comprehensible, predictable and therefore credible as possible. The CNB submits the Inflation Report to the Chamber of Deputies of the Czech Parliament twice a year for review.

The baseline scenario of the forecast described in section II of the Report points to a significant need to ease the monetary conditions further, as the market interest rates consistent with this scenario fall well below zero. Given that assumption, headline inflation will fall to zero in early 2014 owing to a decline in administered prices and an unwinding of the first-round effects of VAT changes, and will then increase again towards the CNB’s target of 2%. Monetary-policy relevant inflation will show similar developments, temporarily turning slightly negative at the start of next year. According to the baseline scenario of the forecast, therefore, both headline and monetary-policy relevant inflation will be below the lower boundary of the tolerance band around the CNB’s target until 2014 Q3.

However, the scope for lowering monetary policy interest rates was exhausted on reaching technical zero (0.05% for two-week repo operations) and market interest rates cannot turn negative in practice. An alternative scenario was therefore drawn up that quantifies the consequences of using the exchange rate as an instrument for easing monetary policy. The CNB has been communicating its readiness to use the exchange rate to prevent the risk of deflation since autumn 2012.

At its latest monetary policy meeting (on 7 November 2013), the CNB Bank Board decided to start using the exchange rate as an additional instrument for easing the monetary conditions. At the same time, the Bank Board agreed that the alternative scenario had become the most likely description of expected future economic developments. As a result, the CNB, acting on the basis of the Bank Board’s decision, started to intervene in the foreign exchange market to weaken the koruna so as to maintain the exchange rate of the koruna against the euro close to CZK 27/EUR.

The exchange rate depreciation will help accelerate the return of inflation towards the CNB’s target of 2%. The probability and robustness of the expected exit from zero monetary policy interest rates has also increased. In the alternative scenario, the weaker exchange rate is reflected in an increase in import prices, stronger economic activity and higher wage growth, which subsequently pushes up both headline and monetary-policy relevant inflation. Inflation returns to the target in 2014 H2.

In the alternative scenario, GDP is affected by several contrary factors. Overall, however, these result in an acceleration of GDP growth overall next year. Although the rise in import prices can be expected to reduce the purchasing power of households, temporarily dampening consumption, household demand is redirected towards domestic goods and services to a greater extent and additionally supported by lower real interest rates as a result of higher inflation expectations. At the same time, the weaker exchange rate supports Czech exports, boosting the competitiveness of corporations and their willingness to invest. The recovery in production then contributes to a rise in employment and wages, increasing the purchasing power and consumption of households in the longer term.

• Full text of the Inflation Report (pdf, 5.5 MB)
• Tables and charts from the Inflation Report (xls)
• Table of key macroeconomic indicators (xls, 69 kB)
• Current CNB forecast

Marek Petruš
CNB spokesman

Selected macroeconomic indicators