"CZKexit" pressure on central bank koruna cap rises as Czech inflation hits target

Czech National Bank in Prague.
By bne IntelliNews January 10, 2017

Czech inflation accelerated to 2.0% in annual terms in December, the statistics office reported on January 10.

The result sees the CPI hit the central bank’s long-term target earlier than expected. That is likely to encourage bets the Czech National Bank will soon drop its cap on the koruna, and therefore lead to a rise in the speculative capital flows that have been arriving in recent months. However, policymakers have already moved the goal posts somewhat, and now insist inflation remains “sustainably” on target before the currency is allowed to breach the CZK27 to the euro level.

Rate setters have committed to keeping the cap until at least the end of March, but had long suggested they would look to inflation as a guide afterwards. That had most predicting the regime – launched in late 2013 in a successful bid to stave off deflation and boost exports – would be scrapped around the middle of the year. However, the rapid recovery in inflation after three years or more of flirting with deflation has taken many by surprise.

Still, the CPI reading in December, the highest in four straight years and which also showed consumer prices rose 0.3% m/m for a third month in a row, was not unexpected. The index has surged throughout the fourth quarter, and that has allowed the CNB to raise its verbal intervention game.

Vice Governor Vladimir Tomsik said recently that a sustainable fulfilment of the inflation target over the longer term is now the key condition for exiting the koruna cap regime. A mere return to 2.0% inflation goal isn’t enough for a policy change, he stated.

The fourth-quarter surge in the CPI pushed the average inflation rate in 2016 to 0.7%. That is well ahead of expectations, and the highest value for the last three years.

The Czech Republic is now illustrating clearly the concerns mounting across the globe that the recent years spent fighting deflation are set to turn to a rapid rise in prices as ultra-loose monetary policy meets the recovery in the global commodities markets. December’s strong inflation was primarily due to a rise in prices in the food and transport segments. Auto fuel prices rose 4.3% y/y.

The result has analysts split on the timing of what they are now terming “CZKexit”. On the one hand, the swift rise of the CPI to target will put pressure on the central bank to drop the cap on the koruna early. Political opposition has been widespread throughout the life of the regime, which is only likely to rise ahead of elections in October. That is seen sparking increased flows of speculative capital betting on a jump in the currency’s value when the limit is relaxed. The central bank is likely to find itself forced into heavier market intervention to keep the cap in place following a drop in pressure in November.

However, the CNB is likely to raise its efforts to talk the market down by reiterating that it will not allow any strong appreciation in the koruna even after the official cap is removed. Analysts still expect the cap to remain in place until at least the middle of the year.

The central bank will also be wary of moving too soon and accidently knocking back the return of inflation. The drivers of the fourth-quarter surge in the CPI remain based in erratic commodities prices, and suggest the effects of the strong labour market and consumption on prices are still yet to emerge.