At its meeting today, the Bank Board of the Czech National Bank decided unanimously to keep interest rates unchanged at technical zero. The Bank Board decided to continue using the exchange rate as an additional instrument for easing the monetary conditions. It confirmed the CNB’s commitment to intervene on the foreign exchange market if needed to weaken the koruna against the euro so that the exchange rate of the koruna is kept close to CZK 27 to the euro. In line with this, the CNB still stands ready to intervene automatically, i.e. without the need for an additional decision of the Bank Board, and without any time or volume limits. The asymmetric nature of this exchange rate commitment, i.e. the willingness only to intervene against appreciation of the koruna below the announced level, is unchanged.
This decision is underpinned by a new macroeconomic forecast. The forecast assumes that market interest rates will be flat at their current very low level and the koruna exchange rate will be used as a monetary policy instrument until mid-2017. Inflation is still well below the CNB’s target of 2%. According to the new forecast, inflation will start rising in the near future, driven by increasing domestic economic activity and wages. At the same time, the anti-inflationary effect of import prices will weaken. Inflation will slightly exceed the 2% target at the monetary policy horizon and then return to it from above. According to the new forecast, sustainable fulfilment of the target, which is a condition for a return to conventional monetary policy, will occur in mid-2017. The Bank Board assessed the risks to the new forecast at the monetary policy horizon as being balanced.
A need to maintain expansionary monetary conditions at least to the current extent persists. The Bank Board therefore states again that the CNB will not discontinue the use of the exchange rate as a monetary policy instrument before 2017. The Bank Board still considers it likely that the commitment will be discontinued in mid-2017. Domestic inflation is still being affected by anti-inflationary cost effects from abroad, especially commodities. Monetary policy looks past the first-round effects of such factors and focuses on any adverse second-round effects. In this context, the CNB still stands ready to shift the exchange rate commitment to a weaker level if there were to be a systematic decrease in inflation expectations manifesting itself in nominal variables, especially wages.
Turning to the assumptions of the forecast regarding developments abroad, economic growth in the effective euro area will fluctuate around 2% over the entire forecast horizon. However, the negative impact of the outcome of the UK referendum on leaving the EU on economic sentiment will result in a temporary slowdown in foreign growth to just under 2% next year. The previous sharp decline in energy commodity prices is reflected in an outlook for continued subdued growth in foreign producer prices, which are not expected to return to annual growth until the start of next year. Consumer price inflation abroad will also rise gradually, but will stay below 2% over the entire forecast horizon. The market outlook for 3M Euribor rates, which is negative until the end of 2018, reflects subdued inflation in the euro area and continued easy monetary policy of the ECB. The market outlook for the Brent crude oil price is gradually rising over the next two years.
Domestic inflation slowed slightly in 2016 Q2 and was still well below the lower boundary of the tolerance band around the CNB’s target. However, core inflation, i.e. adjusted inflation excluding fuels, remains noticeably positive. It reflects the positive effect of growth in the domestic economy and wages. Headline inflation will start to rise in the near future and slightly exceed the 2% target at the monetary policy horizon, i.e. 12–18 months ahead. The increase in the price level will continue to be fostered by favourable developments in the domestic economy, especially rising wages. The pick-up in inflation will also be due to an unwinding of the anti-inflationary effects of import prices and renewed growth in administered prices and food prices. During 2018, inflation will return to the 2% target from above.
Monetary policy-relevant inflation, i.e. inflation adjusted for the first-round effects of changes to indirect taxes, will differ only marginally from headline inflation, deviating downwards from it in 2016 and 2018 and slightly upwards next year. Monetary policy-relevant inflation will therefore also slightly exceed the target at the monetary policy horizon.
The growth of the Czech economy slowed in 2016 Q1 and will moderate further in the rest of the year according to the forecast. This is because gross capital formation will decline this year owing to a drop in government investment co-financed from EU funds. By contrast, the economy continues to be supported by still easy monetary conditions, low commodity prices and rising external demand. After the drop in government investment unwinds, economic growth will pick up to 3% next year amid still robust household consumption. The economy will then grow at the same pace in 2018. The rising economic activity will manifest itself in continued growth in employment, although its pace will slow. This will result in a further, albeit only modest, decrease in the unemployment rate. Wage growth will accelerate further in both the business and non-business sectors.
The forecast assumes that market interest rates will be flat at their current very low level and the exchange rate will be used as a monetary policy instrument until mid-2017. Consistent with the forecast is an increase in market interest rates thereafter. According to the forecast, the return to conventional monetary policy will not result in the exchange rate appreciating sharply to the slightly overvalued level recorded before the CNB started intervening, among other things because the weaker exchange rate of the koruna is in the meantime passing through to the price level and other nominal variables. At the same time, the Bank Board stated that any exchange rate appreciation following the discontinuation of the exchange rate commitment would also be dampened by hedging of exchange rate risk by exporters during the existence of the commitment, by the closing of koruna positions by financial investors and by possible CNB interventions to mitigate exchange rate volatility.
The outlook for both headline and monetary policy-relevant inflation for the next year is slightly higher compared to the previous forecast. This is due to a slightly higher short-term prediction for food and fuel prices, a higher outlook for administered prices and faster observed and expected growth in nominal wages. The inflation forecast is virtually unchanged at the monetary policy horizon (i.e. in the second half of next year). GDP growth this year has been revised slightly upwards, mainly as a result of a somewhat lower downturn in investment than expected. By contrast, the economic growth forecast for 2017 has been lowered owing to a worse outlook for external demand. The assumption of flat market interest rates at their current very low level and the use of the exchange rate as a monetary policy instrument until mid-2017 remains unchanged. The path of market interest rates after the assumed exit from the use of the exchange rate is almost unchanged compared to the previous forecast. In the new forecast, nominal wage growth in the business sector has shifted slightly upwards until mid-2017.
The Bank Board assessed the risks to the forecast at the monetary policy horizon as being balanced. The main uncertainties of the forecast include the impacts of the outcome of the UK referendum on external demand, the effect of the domestic election cycle on public expenditure growth and the depth of the fall in government investment this year. At the same time, the uncertainty surrounding the impact of the long-lasting low inflation on the anchoring of inflation expectations has declined somewhat. In this context, however, the CNB still stands ready to shift the exchange rate commitment to a weaker level if there were to be a systematic decrease in inflation expectations manifesting itself in nominal variables, especially wages. At the same time, the Bank Board states that the CNB will not discontinue the use of the exchange rate as a monetary policy instrument before 2017. The Bank Board still considers it likely that the commitment will be discontinued in mid-2017.