UNIQA Capital Markets Weekly

The dilemma of the Czech National Bank

• The Czech National Bank raises the key interest rate amid accelerating inflation and despite a slowing economy.
• I show the macroeconomic dynamics in a small open economy model for the Czech economy. Given muted growth in the Euro Area, the CNB’s move is ambiguous.

On 6th February, the Czech National Bank (CNB) increased the key interest rate by 25 basis points to 2.25 %. The decision was narrow as four members of the bank board voted in favor, and three members voted for leaving key interest rates unchanged. The decision is underpinned by the new staff macroeconomic forecast. The muted economic growth in the Euro Area will be followed by a gradual acceleration this year. The domestic inflation increased to 3.6 % in January (Figure 1 - see pdf) and is expected to remain above the upper bound of the tolerance band around the inflation target (2 % +/- 1 %-age point).

Inflation is rising due to domestic factors such as changes in indirect taxes and elevated inflation pressures in the domestic economy. In the bank’s projection, inflation will decrease close to the 2 % target until the first half of next year as import prices and administered prices decline and food prices will have an anti-inflationary impact. Fiscal policy will also contribute to a rise in domestic demand via higher public sector pay, pensions and other social benefits. The CNB’s decision is based on the expectation of gradual and moderate acceleration of economic growth this year. The growth of the Czech economy has been slowing but – according to the CNB expecting 2.3 % growth in the entire year – will accelerate helped by a recovery in external demand.

Furthermore, the CNB projects that the CZK/EUR exchange rate will remain stable for the rest of the year after appreciating during Q1. Since January, the koruna appreciated by roughly 2 % against the Euro. The effect of a widening interest rate differential will be offset by weak economic and price growth according to the CNB. Furthermore, the forecast anticipates a rise in the domestic market interest rate that will be followed by a decline in the second half of 2020.

The decision surprises since the European Central Bank (ECB) maintains its expansionary monetary policy inducing upward pressure on the Czech koruna. Appreciation of the koruna lowers inflation (imported goods become cheaper), domestic growth slows (export goods become more expensive), dampening external demand. Hence, a higher exchange has a tightening effect on the economy like an increase in interest rates. Eventually, economic growth has already slowed last year. Furthermore, looking across the region, most central banks keep stable (Poland, Hungary) or have been lowering main policy interest rates (Russia, Ukraine).

The macroeconomic dynamics can be shown in a parsimonious small open economy model following Galí and Monacelli (2005). Figure 2 (see pdf) depicts impulse response functions, which show the response of domestic output (GDP), inflation, monetary policy (nominal interest rate) and nominal CZK/EUR exchange rate changes to one-standard deviation shocks in monetary policy (MP), the terms-of-trade (ToT), domestic technology, foreign output and foreign inflation.

The monetary policy (MP) shock – a rise in the key interest rate – unambiguously lowers inflation and slows growth in the Czech economy. A rising interest rate differential vis-à-vis the rest-of-the-world – proxying the Euro Area (the main trading partner) – appreciates the koruna. (Note that a decrease of the nominal exchange is an appreciation of the Czech koruna). The monetary policy shock showcases the CNB’s current intention to slow inflation by raising the key interest rate.

Euro Area output and inflation shocks are less straight-forward. Assume that growth accelerates in the Euro Area (as the CNB does). The CZK/EUR exchange rate depreciates thereby raising Czech inflation. The CNB tightens monetary policy to contain domestic inflation thereby dampening growth in the domestic economy. This prediction contradicts The CNB’s forecast that domestic growth will accelerate induced by a recovery in Euro Area. In addition, the CNB expects the exchange to remain stable (after initial appreciation in Q1).

In the CNB’s model, the expansionary effect form foreign demand is strong enough to compensate for contractionary monetary policy. Domestic and foreign goods are rather complements and not substitutes since Czech producers are part of the European supply chain, hence, stronger external demand should spur domestic growth. In that sense, my model is unrealistic. However, note the strong propagation of foreign demand on domestic inflation (the size of the inflation response relative to other shocks) displaying the strong linkage to the Euro Area business cycle. Large confidence intervals of the output and monetary policy responses are likely a hint for the ambiguity of the foreign output shock for the domestic economy. Usually, one would expect strong cyclicality between the Euro Area and Czech economy, but bear in mind how CEE economies detached from the weak Euro Area business cycle in recent years due to their strong domestic demand.

Finally, foreign inflation shocks appreciate the currency to which the central bank reacts by relaxing monetary policy. Subsequently, inflation and output rise. This is an unrealistic scenario given subdued inflation dynamics in the Euro Area, however, the large size of the appreciation (compared to the other shocks) suggests a strong linkage to Eurozone inflation.

The CNB faces the dilemma of rising inflation and signs for slowing growth. In a tough decision, the bank’s board decided for an interest rate hike to contain inflation. The CNB’s macroeconomic forecast seems to rest on the expectations of accelerating growth in the Euro Area, which is rather uncertain. My analysis is meant to reveal some of the ambiguity in the interest rate decision. If Euro Area growth disappoints this year, the CNB is set for a U-turn in its monetary policy during the second half of 2020.


References: see pdf-document


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