In November 2013, the Czech National Bank decided to use the koruna exchange rate as an additional instrument for easing monetary conditions. The central bank introduced a currency floor of 27 koruna to the euro. Inflation was heading down, while the policy rate was already cut to close to zero in 2012.
With little room to manoeuvre, the central bank opted to loosen monetary policy further by weakening its currency as opposed to introducing negative rates. In doing so it followed the example of the Swiss National Bank two years earlier, despite not having seen the same amount of appreciation pressure on the koruna as the Swiss had experienced on the franc. The questions now are whether the Czech currency floor is still warranted and how to depart from the floor.
The Czech Republic may have experienced growth concerns and low inflation in 2012/2013, but since the introduction of the currency floor nominal growth has recovered and substantially outperformed the Eurozone. Inflation is on the rise (see chart) and is currently running above the central bank's inflation target of 2%. This in itself warrants tighter monetary policy, but so far the central bank has resisted and is erring on the side of caution.
Too loose monetary policy, however, can result in an overheating economy and push up inflation beyond acceptable levels, while too weak a currency can result in a growing current account surplus. Both are happening, and as a result capital is flowing into the Czech Republic for fundamental and speculative reasons.
To defend the floor against a backdrop of inflows the central bank needs to intervene in the currency market, which could be reflected in a growing balance sheet amid rising foreign exchange reserves (see chart).
However, a growing balance sheet poses problems in itself. It increases koruna liquidity in the system, which could be inflationary and may require central bank sterilisation at a cost. Moreover, if the floor goes, the central bank will incur a loss on its foreign exchange holdings. As such we believe there is a limit to the size of a central bank's balance sheet; something we have learned from the Swiss experience as well.
Since the introduction of the floor, the Czech central bank has repeatedly confirmed the validity of this exchange rate commitment. At its most recent meeting on 2 February 2017, the bank board stated again that the central bank would not discontinue the use of the exchange rate as a monetary policy instrument before the second quarter of 2017, but also said it is likely that the commitment will be discontinued in mid-2017.
The Czech economy doesn't need a weak currency, while the central bank is now required to intervene heavily to keep the floor intact. With the genie out of the bottle speculative inflows are likely to increase, making it even harder for the central bank to defend the floor. We therefore believe that the floor could go in the near future, without much advance notice!