Czech Republic: Central Bank weighs low inflation against improvements in labor market
June 30, 2016
At its 30 June board meeting, the Czech National Bank (CNB) decided to hold its two-week repo rate at its so-called “technical zero” of 0.05% and affirmed its 27 CZK per EUR exchange rate floor, which the koruna is not permitted to appreciate beyond. The CNB is using near-zero interest rates, as well as the currency floor, to bring inflation closer to its 2.0% target. Although recent data indicate that inflation is still well below target, improvements in the labor market are expected to put upward pressure on wages, meaning that the CNB can afford to hold off on any further policy easing.
The CNB noted that inflation is still being affected by external events, including low energy prices, and expects such effects to fade in the second half of the year. The artificially-weak koruna is also helping to keep prices for imported goods high. However, the political and economic ramifications of the Brexit referendum have cast uncertainty over European inflationary pressures, which the CNB felt was best addressed by stability in its policy stance. As per the Bank’s previous statements, it reserved the right to use the exchange rate floor as the primary monetary policy tool until mid-2017, after which the Bank foresees a return to conventional monetary policy.
Inflation fell to 0.1% in May, from 0.6% in June. Although inflation has moved in the wrong direction, the CNB sees inflation picking up later this year as the labor market tightens. Wage growth was faster than expected in the first quarter, and retail sales also picked up. These development suggest a subsequent rise in inflation. Moreover, wage growth appears to be faster for low-income employees compared to those with high incomes, which suggests that firms are seeking new entries into the labor market. This not only bodes well for inflation expectations, but it also gives a good indication of the health of the economy overall.
The economy is growing steadily and domestic demand does not appear to be affected by low inflation. This has resulted in a sharp increase in the number of Czech securities owned by foreign investors, who expect the value of these notes to increase once the currency floor is removed and the koruna is allowed to appreciate. This, in turn, has increased concerns of instability once the currency floor is abandoned. Petr Sklenar, Chief Economist at J&T Banka, noted that although it is not clear how the Bank will abandon its currency floor, the current regime will likely be in place for at least the next 12 months:
“We do not see any change in forecasting the time of the exit from the current monetary regime. The exit remains very unclear in terms of time and form. The CNB initially stated that the koruna cap would be kept for slightly over a year and its abandonment would be followed by an interest rate hike. Nevertheless, after two-and-a-half years of the weaker koruna, the central bank is now considering negative rates as a tool to smooth the path in exiting the currency regime. Further, the date of exit has been repeatedly postponed. In addition, the CNB unexpectedly mentioned in the two last meetings that it is ready to weaken the koruna again if the nominal wage growth remains mild. The uncertainty has not faded away, but has remained the same if not higher. In our view, the exit will simply happen sometime in the future and, for example “mid-2017” or “early 2018” are both likely timeframes.”
As low inflation does not appear to be dragging on domestic demand, there is little reason for the CNB to move its policy rate into negative territory or to make alterations to its currency floor. Should this change, possibly as a result of Brexit, we could see more action from the CNB. Following June’s meeting, CNB board member Jiri Rusnok replaced Miroslav Singer as governor as of July. The next meeting is scheduled for 4 August.
Author: Robert Hill, Economist