CNB may drop benchmark rate to negative next year

The Czech Nation Bank’s minimum exchange rate of 27.00 still determines the EUR/CZK exchange rate. In the first half of 2016, the central bank had to continue to actively defend the floor by intervening in the foreign exchange market that added up to EUR 4.1 billion after the hefty EUR 8.3 billion in second half of 2015.

The requirement has increased for intervention because the CNB Board is actively hinting that it would end FX targeting around mid-2017. As the deadline approaches, if the central bank does not hint any rethinking of its stance, there might be solid speculative inflows and strengthening pressure on CZK.

Board members of Czech National Bank had discussed negative interest rates actively until one quarter ago; however, the latest guidance shows that the central bank is satisfied with the rising of core inflation and that no additional expansion of monetary policy would be required, noted Commerzbank in a research report.

There are varied views within the board regarding the outlook of inflation and the requirement for additional easing of monetary policy. Moreover, there might be a brief spurt of base effect driven inflation acceleration that the central bank might misinterpret as permanent. This makes it quite challenging to forecast precisely when the Czech National Bank might exit the FX cap, said Commerzbank.

“Our baseline scenario is that CNB will sense that inflation is not picking up permanently and that growth dynamics are worsening too, and it will drop its benchmark rate to negative before next year-end, and also extend the EUR/CZK floor of 27.00 until the end of 2017”, added Commerzbank.

It is tough to see how the central bank might dismantle the EUR/CZK floor at the same time that it is attempting to stimulate inflation. Dismantling the floor might result in immediate and considerable appreciation pressure on CZK that might offset rate cuts and require rates to decline quite deeper into negative in order to attain the same result, stated Commerzbank.

“We do not think that CNB will pursue mutually contradictory policies in this manner even though there may be political opposition to the EUR-CZK floor. This is why we expect the floor to be extended”, said Commerzbank.