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 without any time or volume limits. The asymmetric nature of this exchange rate commitment is unchanged.
This decision is underpinned by a new macroeconomic forecast. The forecast assumes that the exchange rate will be used as a monetary policy instrument until mid-2017. Inflation is starting to rise, but it is still well below the CNB’s target of 2%. According to the forecast, inflation will increase further and slightly exceed the 2% target at the monetary policy horizon. During 2018, it will return to the target 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 from mid-2017 onwards.
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 Q2. The Bank Board still considers it likely that the commitment will be discontinued in mid-2017.
According to the assumptions of the new forecast, economic growth in the effective euro area will slow next year. It will reflect, among other things, the impacts of the result of the UK referendum on economic sentiment. Growth in the Czech Republic’s major trading partner countries will return to 2% in 2018. The decline in industrial producer prices in the euro area, which mainly reflects low energy commodity prices, has already started to fade. These producer prices will return to year-on-year growth at the start of next year. Consumer price inflation abroad will also go up gradually. However, it will stay below 2% until the end of 2018. The outlook for three-month EURIBOR market interest rates is negative over the entire forecast horizon. It thus reflects the continued easy monetary policy of the European Central Bank. This is contributing to expectations of a further slight depreciation of the euro against the US dollar. The outlook for the Brent crude oil price is gradually rising.
Domestic inflation increased slightly in 2016 Q3 but stayed well below the CNB’s target. However, the anti-inflationary cost factors from abroad are already starting to fade and their effect will disappear next year. Core inflation, i.e. adjusted inflation excluding fuels, remains distinctly positive. It reflects the positive effect of growth in the domestic economy and wages. Inflation will continue to rise on account of the above factors and will slightly exceed the 2% inflation target at the monetary policy horizon, i.e. in late 2017/early 2018.
Monetary policy-relevant inflation, i.e. inflation adjusted for the first-round effects of changes to indirect taxes, will deviate only marginally from headline inflation. It, too, will therefore slightly exceed the 2% target at the monetary policy horizon.
The growth of the Czech economy eased slightly in Q2. It will reach 2.8% in 2016 as a whole. This slowdown was due to a temporary drop in government and corporate 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. In the next two years, economic growth will maintain a similar pace as this year. On the one hand, growth in investment will resume, but on the other hand domestic economic growth will be dampened somewhat by a temporary slowdown in external demand and later also less easy monetary conditions following the discontinuation of the CNB’s exchange rate commitment. The continued economic growth will lead to higher wage growth. The unemployment rate will decrease only slightly.
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. 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 again that any exchange rate appreciation following the discontinuation of the exchange rate commitment would be dampened, among other things, by hedging of exchange rate risk by exporters during the existence of the commitment, as well as by the closing of koruna positions by financial investors. In addition, the CNB will stand ready to intervene to mitigate exchange rate volatility.
Compared to the previous forecast, the outlooks for headline and monetary policy-relevant inflation are slightly lower. The forecast for Czech economic growth this year has been revised slightly upwards. By contrast, the economic growth forecast for the next two years has been lowered marginally owing to a worse outlook for external demand and weaker growth in private investment. The rise in interest rates after the exit from the CNB’s exchange rate commitment, which the forecast continues to assume will occur in mid-2017, is slower than in the previous forecast.
The Bank Board assessed the risks to the inflation forecast at the monetary policy horizon as being balanced. The uncertainties of the forecast include the speed of return to growth in government and corporate investment, the effect of the election cycle on discretionary government expenditure, the impacts of the outcome of the UK referendum and the future settings of the monetary conditions of the major central banks.