Czech holds rate, lowers inflation outlook slightly

      The Czech central bank left its benchmark two-week repo rate at 0.05 percent in the board’s first decision following last month’s exit from using the exchange rate as a tool to ease monetary conditions, and lowered slightly its forecast for inflation and domestic market interest rates.
      The Czech National Bank (CNB) on April 6, 2017 decided to stop enforcing a cap of 27 koruna to the euro on confidence that it would now be able to meet its 2.0 percent inflation target.
      The CNB began using the exchange rate in November 2013 as an additional tool to stave off deflation after its key rate was cut the current level of effectively zero in November 2012.
      As expected, the koruna immediately jumped to around 26.5 to the euro from 27.03 in volatile trading following the lifting of the exchange rate cap. Since then it has eased and was today trading around 26.8 to the euro.
      By discontinuing its exchange rate commitment, the CNB has now returned to a conventional monetary policy regime with interest rates as its main tool.
      However, the central bank said the koruna’s exchange rate was the main uncertainty surrounding its economic forecasts, with possible fluctuations in either direction.
    “Subsequent interest rate increases will be conditional on the evolution of all key macroeconomic variables, including the exchange rate of the koruna,” the CNB said, adding that it remains ready to use all its instruments to mitigate any potential excessive exchange rate fluctuations.
     In its latest forecast, the CNB expects the koruna to appreciate against the euro due to a positive interest rate differential to the euro in light of the European Central Bank’s quantitative easing. However, the the central bank added that its forecast did not take into account the any rise in the koruna may be strongly dampened by investors’ “overboughtness.”
     Czech interest rates are forecast to move higher in the third quarter of this year and 2018, with the 3-month PRIBOR (the Prague interbank market rate) rising to 0.8 percent from 0.5 percent this year. This 2018 forecast is down from its previous forecast of 1.1 percent, with any rate increases dampened until mid-2018 due to the ECB’s asset purchases.
     Inflation in the Czech Republic is seen remaining in the central bank’s upper half of its tolerance bank for the rest of this year before easing to 2.1 percent in the second quarter of 2018 and to 2.0 percent in the third quarter – down from the previous forecast of 2.3 and 2.1 percent, respectively –  as one-off factors unwind.
     Headline inflation rose to 2.6 percent in March from 2.5 percent in February for the highest rate since November 2012. The CNB has a one percentage point tolerance band around its 2.0 percent midpoint target.
     The economy is seen growing by 2.9 percent this year, up from its previous forecast of 2.8 percent, and then growing by 2.8 percent in 2018, driven by household consumption, a gradual recovery in investment and further growth in external demand.
      The Czech economy grew 2.3 percent last year, down from 3.5 percent in 2015.

    The Czech National Bank issued the following statement:

“At its meeting today, the Bank Board of the Czech National Bank decided unanimously to keep interest rates unchanged. The exit from the exchange rate commitment was the first step towards a gradual return of the overall monetary conditions to normal. Subsequent interest rate increases will be conditional on the evolution of all key macroeconomic variables, including the exchange rate of the koruna. The CNB still stands ready to use its instruments to mitigate potential excessive exchange rate fluctuations if needed. 
According to the new macroeconomic forecast, inflation will stay in the upper half of the tolerance band around the 2% target this year and return to the target early next year. At the monetary policy horizon, inflation will be very close to the target. Consistent with the forecast is an increase in domestic market interest rates in 2017 Q3 and later also in 2018.
According to the assumptions of the new forecast, economic growth in the effective euro area will gradually increase towards 2%. At the start of this year, inflation in the euro area reflected, among other factors, strong year-on-year growth in prices of oil and other commodities. After this factor abates, the current high growth in industrial producer prices will also decrease. Consumer price inflation in effective terms should be flat at roughly the current level this year and accelerate towards 2% next year. The outlook for 3M EURIBOR market interest rates reflects the continued easy monetary policy of the European Central Bank and is negative over the entire forecast horizon.
The euro-dollar exchange rate is expected to remain broadly stable. Likewise, the outlook for the Brent crude oil price foresees stability close to the current level.
According to the forecast, domestic inflation will stay in the upper half of the tolerance band for the rest of this year. It will decline towards the 2% target at the start of next year and will be very close to it over the monetary policy horizon, i.e. in 2018 Q2 and Q3. In addition to core inflation, rapid growth in food and fuel prices is contributing to the higher inflation this year. The expected decline in inflation in early 2018 will be due to an unwinding of one-off factors observed in late 2016 and early 2017. It will be supported by a recovery in labour productivity growth, which will reduce the currently peaking cost pressures from the domestic economy. A renewed anti-inflationary effect of import prices connected with the forecasted appreciation of the koruna will act in the same direction.
The growth of the Czech economy will rise to almost 3% this year. The domestic economy will maintain a similar pace next year. Growth in economic activity will be driven mainly by robust growth in household consumption and a gradual recovery in investment. The economy will benefit from further growth in external demand. The continued domestic economic growth will manifest itself in rising tightness in the labour market. This will result in a further acceleration in wage growth.
The forecast assumes that interest rates will remain at the current level in Q2 following the exit from the exchange rate commitment in April. Thereafter, an increase in domestic market interest rates in 2017 Q3 and later also in 2018 is consistent with the forecast. The rate increase will be strongly dampened until around mid-2018 by the European Central Bank’s currently ongoing quantitative easing. According to the forecast, the koruna will appreciate due, among other factors, to continued real convergence of the Czech economy to the euro area countries. According to the forecast, appreciation will also be fostered by a positive interest rate differential vis-à-vis the euro area and this year’s asset purchases by the European Central Bank. However, the exchange rate forecast does not take into account that the appreciation may also be strongly dampened in the coming quarters by market “overboughtness”. 
Compared to the previous forecast, the inflation outlook is slightly lower over the monetary policy horizon. This is despite currently stronger inflation pressures, which will, however, weaken in the quarters ahead. The effect of import prices will be more anti-inflationary than in the previous forecast, reflecting the slightly earlier exit from the exchange rate commitment compared to the assumptions of the previous forecast. This is also reflected in the path of market interest rates, which has shifted towards slower growth in rates. The GDP growth forecast is little changed.
The CNB Bank Board assessed the risks to the new inflation forecast at the monetary policy horizon as being slightly inflationary. The path of the exchange rate is still the main uncertainty of the forecast. The exchange rate may fluctuate in either direction after returning to the standard form of managed floating. Compared to the forecast, it may be weaker on average owing to the absence of a counterparty for the closing of koruna positions by financial investors. The extent to which the current inflation pressures are fundamental and persistent is also uncertain. The uncertainties regarding future economic developments also include domestic and foreign political risks.”