23rd March 2020

March: the month of interest rate cuts

In an extraordinary meeting on Monday 16 March, members of the Czech National Bank’s board voted unanimously to cut the bank’s key repo rate by an exceptional 50bp. It did so in anticipation of the economic impact of measures introduced in the Czech Republic to prevent the spread of COVID-19 virus. The CNB thus followed on from other central banks across the world, some of which had made multiple cuts. The US Fed for example, in two meetings held within a relatively short timeframe, cut interest rates by 150bp. Given how long it usually takes for monetary policy to be implemented through interest rate adjustments, we believe the current reaction of central banks is intended to have more to send a signal, aimed at calming the financial markets. It should also serve as a preventative measure in if the current situation were to last and lead to the underfinancing of economic agents.

The CNB is in a difficult position, as it continues to combat high inflation, which is above the bank’s 2% target and also repeatedly above its forecasts. This was the reason why the bank increased its two-week repo rate at the beginning of February. The growing number of coronavirus cases in recent days has resulted in a turnaround in Czech monetary policy. According to CNB governor J. Rusnok, the bank’s board is aware of the dilemma in terms of its current monetary policy, but it now prefers to support the real economy even if that means not meeting its inflation target. We see two reasons for this: On the one hand, combatting the recent high inflation through forward-looking monetary policy is a losing battle and on the other hand, the expected slowdown in demand is likely to contribute to a gradual decrease in inflation, as should record low oil prices.

The halt in production in the automotive industry is another hit for Czech economic growth and we expect the CNB to react with another 50bp rate cut at its regular monetary policy meeting this Thursday. The bank’s board will likely receive a full set of analytical materials, probably also including the updated forecast. The forecast should outline the economic consequences of measures implemented to prevent the spread of COVID-19 in the Czech Republic. We can expect a hard hit on economic growth from the halt in automotive production and the shutdown of most services. We also note the automotive industry’s significant contribution to Czech added value. The critical question therefore is, how long could it take to overcome this situation. Compared to other analysts, our estimates are conservative, forecasting economic stabilisation in the third quarter and a return to growth in the fourth quarter of this year. The main risk here is of the CNB assessing the effects on the Czech economy as even more serious and cutting rates by over 50bp. It has sufficient space to do so.

The koruna has weakened vs the euro at above 27 CZK/EUR and eased monetary conditions further, but this also poses a risk of higher inflation in the near future. The koruna started depreciating early Monday morning in anticipation an interest rate cut and continued to do so after the decision. In the course of the week it occasionally hit the 28 CZK/EUR mark. As the CNB is aware of the rapid knock-on effect of weaker exchange rate on domestic prices, it announced its readiness to intervene on FX market to defend the strongly depreciating koruna. It accumulated sufficient foreign reserves during the period of exchange rate commitment in 2013-2017. However, a value that would trigger the CNB’s action was not stated. We attribute the weakening of the domestic currency in recent days to a sell-off of long FX positions on the Czech koruna. These positions were taken at the time of CNB’s exchange rate commitment. Market expectations of the interest rate cuts could explain this sell-off. The weaker koruna is the reason why we forecast interest rate stability for the rest of this year. In 2021, we expect the rebound in Czech economic growth to lead to a gradual normalisation in monetary policy, consisting of both increased interest rates and stronger exchange rate. The recent sell-off of the Czech koruna should contribute to this.

Unlike other central banks, we do not expect the CNB to introduce quantitative easing. This would be in keeping with comments by some of its board members. According to the CNB, the Czech money market has enough liquidity, but last week it did nevertheless announce a decrease in the reverse repo rate, serving as a liquidity provision, of 10bp. It also increased the frequency of auctions for reverse repo operations from one per week to three. Both serve as precautionary measures. The central bank also reversed its previous decision to increase the counter cyclical buffer since 1 July 2020 to 2%, leaving it unchanged at 1.75%. We would expect it to ease bank lending conditions for businesses and households.

Members of the American Chamber of Commerce in the Czech Republic