2. The Czech National Bank and its role in the economy

The Czech National Bank is the central bank of the Czech Republic. It is established by the Constitution of the Czech Republic. It began to function when the Czech Republic was founded on 1 January 1993. Under Article 98 of the Constitution – and in accordance with EU primary law – the primary objective of the CNB is to maintain price stability. The Constitution further stipulates that interventions in the CNB’s activities are only permissible on the basis of a law.

Since its establishment, the CNB has been one of the supervisory authorities for the Czech financial sector. In 2006, all the supervisory institutions in the Czech Republic were integrated into the CNB. So, in addition to its primary objective of ensuring price stability, the CNB started to take care of the stability and sound development of the entire Czech financial system.

The CNB carries out its activities on the basis of the Act on the Czech National Bank (Act No. 6/1993 Coll., as amended) and other legal regulations. The Act on the CNB enshrines its role as the supervisory and resolution authority for the Czech financial market. The CNB performs its activities through its head office in Prague and through representative offices in some regions.

The supreme governing body of the CNB is the Bank Board, which has seven members – the Governor, two Deputy Governors and four other Bank Board members. All Bank Board members are appointed by the President of the Czech Republic for a maximum of two six-year terms.

Since the Czech Republic joined the EU, the CNB has been part of the European System of Central Banks (ESCB), which consists of the ECB and the national central banks of all EU Member States. The Governor of the CNB is a member of the General Council of the ECB, which comprises the President and the Vice-President of the ECB and the governors of the national central banks of all EU Member States. Through its membership in many European bodies and institutions, the CNB as a financial market supervisor helps to shape the single European financial services market. Moreover, the CNB is actively involved in the activities of international organisations. This gives it a say in the creation of international standards for the regulation and supervision of the financial market. It is part of the European System of Financial Supervision (ESFS) and participates directly in the activities of the European Systemic Risk Board (ESRB).

For more details, see About the CNB.

The mandate of the CNB is based on the Act on the Czech National Bank (Act No. 6/1993 Coll., as amended). The primary objective of the CNB is to maintain price stability. Without prejudice to its primary objective, the CNB supports the general economic policies of the government leading to sustainable economic growth.

In line with its primary objective, the CNB:

• sets monetary policy, through which it ensures price stability,
• works to ensure financial stability and the safe and sound operation of the financial system in the Czech Republic,
• issues banknotes and coins,
• manages the circulation of currency, administers clearing between banks and contributes to the safety, soundness and efficiency of payment and settlement systems and to the development thereof,
• supervises the activities of entities operating on the financial market, and
• carries on other activities pursuant to this Act and special legal rules.

As the central bank of the state, the CNB provides banking services to the state and the public sector. It maintains the accounts of organisations and persons directly connected to the state budget. By agreement with the Ministry of Finance, the CNB conducts transactions relating to government bond issues and financial market investments pursuant to the budgetary rules.

Inflation means an increase in the general price level of goods and services in the economy. A decline in inflation (i.e. a slowdown in the rate of increase in the price level) is called disinflation. If the price level of goods and services in the economy is falling, i.e. inflation is negative, we speak of deflation. Inflation can also be defined as a decline in the real value (i.e. purchasing power) of money.

The best known and most watched inflation measure is consumer price inflation, i.e. the increase in the consumer price index (CPI). However, other indices are monitored, such as the industrial producer price index, the agricultural producer price index and the gross domestic product deflator. Prices of individual categories of goods or services, such as food prices, transport prices and prices in restaurants and hotels, are also tracked within consumer price inflation. In the Czech Republic, inflation is measured and published every month by the Czech Statistical Office (CZSO). The CZSO also publishes inflation for selected groups of the population, such as households of pensioners.

International comparisons of inflation should be based on data published by Eurostat, the European statistical office. Eurostat publishes HICP inflation, i.e. the increase in the harmonised index of consumer prices. It may differ from the CPI inflation published by the CZSO, because these two indices, among other things, take a different approach to “imputed rent”, which reflects the cost of owner-occupied housing and partly therefore the evolution of house prices. Imputed rent accounts for more than 10% of the consumption basket in the Czech national CPI but is absent from the HICP. The methodological differences between these two ways of measuring the price level are discussed in more detail in an article in the Autumn 2021 Monetary Policy Report.

The rise or fall in prices, or the change in the price level, over a given period of time is indicated by the inflation rate, calculated as the percentage increase in the consumer price index. However, the term “inflation” is often used as a shorthand for the inflation rate. It is important to give the period for which the inflation rate is reported and the base against which the period is compared. The following inflation rates are most commonly quoted:

• monthly inflation, i.e. the inflation rate expressed as the increase in the consumer price index compared with the preceding month (e.g. June 2024 versus May 2024), which is the best indicator of the current change in the price level;
• annual inflation, i.e. the inflation rate expressed as the increase in the consumer price index compared with the same month of the preceding year (e.g. June 2024 versus June 2023), which is the most commonly quoted measure of consumer price inflation and is used, for example, to calculate the real interest rate, real asset price growth and indexations;
• the average annual inflation rate, i.e. the inflation rate expressed as the increase in the average annual consumer price index, which expresses the percentage change in the average price level over the last 12 months compared with the average for the previous 12 months. It is taken into account mainly in calculations of real wages, pensions and so on, and usually also appears in lease agreements and other long-term commercial contracts. It reflects the evolution of prices over an entire year and is the least prone to sudden fluctuations.

In conducting monetary policy, the CNB reacts to “monetary policy-relevant inflation”, defined as headline inflation adjusted for the first-round effects of changes to indirect taxes, such as VAT and excise duties. Changes in the level and structure of indirect tax rates are a specific type of exogenous shock to which the CNB applies an “escape clause”, i.e. an exemption from its obligation to fulfil the inflation target. The CNB reacts in a forward-looking manner to ensure that monetary policy-relevant inflation is close to the 2% inflation target at the monetary policy horizon (i.e. about 12–18 months ahead).

The need to apply escape clauses is driven by the view that it is not economically optimal to react to the direct impacts of one-off changes in factors that lie beyond the central bank’s control. These often involve administrative or regulatory measures or supply-side shocks (such as changes in commodity prices) that are entirely or largely beyond the reach of monetary policy. In such circumstances, efforts by the central bank to keep inflation on target would lead to undesirable swings in economic growth and employment while no longer having the potential to affect past inflation. The CNB therefore does not react to the first-round effects of such one-off fluctuations (it applies escape clauses to them). However, if these surprises raise the inflation expectations of economic agents, the CNB will react by changing monetary policy.

Prices play a crucial role in a market economy. They are the result of the interaction of many demanders and suppliers in many markets. They provide understandable information about which goods or services are in demand and how costly it is for firms to supply them to the market. Prices thus enable effective interaction between demand and supply. If the price level in the economy is relatively stable, firms can react flexibly and easily to changes in prices of individual goods or services by redirecting the available resources to the production of goods and services that are more in demand or, conversely, by reducing the supply of what is less in demand.

However, if there are frequent and significant increases in the prices of most goods and services, i.e. high inflation, it is more difficult for firms and households to find the optimal use of the resources available. High and variable inflation also makes financial planning difficult for firms and households, as the measure of value constantly shifts and future changes are difficult to predict. This leads to more frequent planning errors, and the uncertainty about the future value of money is itself perceived negatively.

Moreover, high inflation introduces further distortions into the economy. It imposes costs on firms in the form of frequent price changes. It tends to distort the tax system, as many taxes are set as a flat rate and not as proportional to the price level. High inflation leads to a redistribution of wealth from lenders to borrowers, from holders of cash to holders of real assets, from those on fixed incomes to those on flexible incomes, and so on. In extreme cases, high inflation leads to the use of foreign non-inflationary (reserve) currencies, an increase in the popularity of gold, or a shift to barter trade (the exchange of goods for goods without the use of money).

Generally, high inflation is more variable and therefore more difficult to predict. Investors demand compensation for this uncertainty in the form of a higher risk premium, resulting in a higher real interest rate. The upshot is a decline in investment in long-term projects, the very projects that usually contribute most to long-term economic growth.

Deflation is a term referring to a decline in most prices in the economy. It is therefore the opposite of inflation. The situation where prices fall across the board due to a lack of demand is particularly undesirable. A decrease in prices causes the real value of cash and short-term deposits to increase, so that both become profitable assets. By contrast, returns on longer-term investments become uncertain. This increases the incentive to hold cash. Consumers may postpone their consumption and investment spending in anticipation of a further decline in prices. This reduces effective demand in the economy, which in turn pushes prices down further, slows the economy and causes unemployment to rise.

Similarly, companies prefer to postpone investments in new projects and equipment because they expect lower demand and thus lower returns on investment. Falling prices lead to falling wages. This further reduces aggregate demand, pushes prices even lower and slows economic activity. A “deflationary-recessionary spiral” forms. There is “money illusion” – people do not directly associate the fall in their wages with the fall in the price level, but consider it a very negative phenomenon and rein in their spending in response.

When a deflationary spiral occurs, it is difficult for central banks to stabilise and influence the economy, because conventional monetary policy instruments such as interest rates can hit their lower bound. The central bank thus loses its main instrument and has to look for unconventional ones.

Inflation targeting is currently one of the most frequently used regimes under which advanced central banks conduct monetary policy. The key features of inflation targeting are a publicly announced inflation target, the use of macroeconomic forecasting, and open communication by the central bank with the public.

Inflation targeting provides a structure for monetary policy decision-making. In addition to facilitating decision-making itself, this structure makes it easier for the public to interpret the central bank’s decisions. Other monetary policy regimes include a regime with an implicit nominal anchor (where the central bank targets a particular variable adopted internally within the central bank without it being announced explicitly), money targeting and exchange rate targeting. For more information on the different monetary policy regimes, see “What are the regimes of monetary policy?”.

The CNB has been targeting inflation since 1998. It chose this regime after it was forced to abandon the fixed exchange rate in May 1997. Money targeting – the system it had been using until then – had proved incapable of anchoring inflation expectations, which had been badly shaken by currency turbulence at the time. (More details are available at Historie ČNB – Cílování inflace; in Czech only.) At the time, inflation targeting was being applied by just a few advanced central banks, and even they had not been using it very long – the first country to introduce inflation targeting was New Zealand in the late 1980s. The Czech Republic was the first transition country to adopt this regime with a view to reducing inflation and stabilising it at low levels.

Central banks, including the CNB, are “forward-looking” in targeting inflation. When setting monetary policy, they react not to current inflation but to future inflation (or rather to the forecast for inflation) and to inflation pressures that will affect future inflation. The distance into the future that central banks focus on is determined by the time lag of the effects on inflation of monetary policy measures taken in the present. This period in which current monetary policy measures will have the greatest impact is called the monetary policy horizon. In the case of the CNB, it is roughly 12–18 months ahead.

The CNB’s inflation-targeting regime is termed flexible inflation targeting. In short, this means that the central bank does not strive to achieve the inflation target at any cost and at every moment in time, but takes account of real economic developments so that monetary policy does not cause undesirable swings in economic activity and employment. Inflation may deviate from the inflation target as a result of unforeseeable shocks that affect the economy on an ongoing basis (such as natural disasters and surges in energy prices) or as a result of administrative and regulatory measures (such as changes to indirect taxes). A central bank that tried to achieve the inflation target in all circumstances would be pursuing “strict” inflation targeting. In reality, however, no central bank in the world applies an entirely strict approach to its inflation target.

The CNB’s inflation-targeting regime has evolved over time. Particularly significant changes have been made in the area of forecasting and monetary policy communication. In July 2002, the CNB became one of the first banks in the world to abandon the assumption of constant interest rates in its forecasts (i.e. to switch to “unconditional” forecasts). In 2008, the CNB replaced its original core semi-structural quarterly projection model (QPM) with a dynamic stochastic structural general equilibrium model called g3. In 2019, this model was reworked on the basis of experience from its use and current trends in macroeconomic modelling, and was renamed g3+. In 2024, g3+ was further upgraded to reflect the extraordinary economic developments of the previous few years and the forecasting experience gained since it was put into practice. In addition, in the same year, the CNB, like a number of other central banks, commissioned an external review of its monetary policy analytical and modelling framework. The CNB has thus kept abreast of the latest trends in the use of modelling to support monetary policy decision-making.

In parallel with refining its forecasting techniques, the CNB has become more open. At the start of 2008, it started to disclose the forecast-consistent interest rate path in numerical form and the votes cast by the board members on interest rate changes by name. At the beginning of 2009, the CNB also started to publish the forecast-consistent path of the nominal koruna-euro exchange rate. Since February 2020, the CNB has been publishing attributed minutes of its monetary policy meetings, and since June 2022, it has also been publishing attributed minutes of its financial stability meetings. This makes it one of the most transparent central banks in the world.

Since inflation targeting was launched in 1998, the CNB’s inflation targets have been progressively adjusted to the needs of the transforming economy. In the initial years, they were set in terms of net inflation, i.e. the consumer price index adjusted for administered prices and changes to indirect taxes. The inflation targets took the form of a range and their fulfilment was only assessed as of the last month of the year.

In 2002, the CNB switched to targeting headline inflation. It therefore began to set its inflation targets in terms of year-on-year growth in the consumer price index, which is easier for the public to understand and can better anchor inflation expectations. Between 2002 and 2005, the target took the form of a linearly descending band. In January 2002, the band was 3–5%. It was then lowered gradually to the envisaged level of price stability (2–4%), to be achieved in December 2005.

The CNB also announced a set of exemptions (“escape clauses”) from its obligation to hit the inflation target. These cover exogenous and unpredictable factors (such as changes in world prices of raw materials, energy and commodities, non-fundamental exchange rate developments and natural disasters) that lie completely or largely outside the reach of monetary policy measures and justify the CNB not to respond directly to the above-mentioned shocks with monetary policy measures.

Since 2006, the inflation target has taken the form of a single point. It was initially set at 3%, i.e. in the middle of the previous target band. At the same time, the CNB undertook to respond with its monetary policy to ensure that inflation does not deviate from this target by more than one percentage point in either direction. Measured inflation deviates from the inflation target partly because of unforeseeable shocks that hit the economy in the medium term. The central bank cannot always return inflation to the target immediately, nor is it meaningful for it to do so from the macroeconomic point of view. Inflation therefore fluctuates slightly around the target.

In 2010, the inflation target was lowered to the present level of 2%. The CNB’s current target is in line with the practice of central banks in advanced economies.

Chart – History of inflation targets

Since 2010, the CNB’s target has been set at 2%, in line with the practice of central banks in advanced economies. But why is there a consensus among developed countries that central banks should not aim for zero inflation? An inflation target of around 0% looks tempting at first sight and is achievable in principle through monetary policy, but in practice it hides a number of complications.

One reason is the measurement of inflation itself. Measured inflation is always subject to some error. Measurement errors can go in either direction, but there are reasons why inflation tends to be overestimated in the long run (i.e. the officially reported figure is somewhat higher than the “true” inflation rate). These reasons are linked with difficulties in assessing changes in the quality of consumer goods. For example, new mobile phones are going up in price, but this tends to be associated with an increase in their quality. Many economists have tried to quantify – at least approximately – this systematic bias towards overestimating inflation. Their estimates range around one percentage point per year, but for some countries the figure is considerably higher. Another source of the overestimation of measured inflation is that consumer price indices usually assume that consumption behaviour remains unchanged when prices change. In reality, however, when different prices rise by different amounts, consumers prefer to buy goods and services that increase less in price. This means that measured inflation is rather higher than the true change in the cost of living for the typical consumer. Taking these factors into account, moderate measured inflation can be considered de facto price stability.

Another reason for targeting 2% inflation is that moderate price growth facilitates change in the relative prices of goods and services, thus allowing, for example, for better adjustment to changes in demand. If the demand for a product (for example, a new model of telephone) increases, it is easier to increase its relative price (its price relative to the prices of other products) by making it more expensive than by lowering the prices of all other products that are less in demand.

Moderate inflation can also reduce growth in unemployment when the economy slows, as it causes real wages to fall moderately given constant nominal wages. This allows struggling firms to reduce their real costs without lowering nominal wages, which are downwardly sticky because pay cuts tend to be unacceptable to unions and employees.

Moderate inflation also makes it easier for central banks to conduct monetary policy. An economy that operates with near-zero inflation in the long run will necessarily have relatively low interest rates. But this greatly raises the probability that, in times of recession, interest rates will hit the zero lower bound and the central bank will thus lose its main monetary policy instrument. In such cases, central banks then have to resort to unconventional monetary policy instruments, which entail additional costs. In addition, a moderately positive inflation target provides a cushion against deflation and its negative consequences.

A central bank is independent if it does not have to consider short-term political pressures in its decision-making and can focus on achieving its long-term objectives, which in the case of the CNB are primarily price stability and financial stability. These are beneficial to the economy in the long run but may have costs in the short run. If the costs of monetary policy were to start manifesting themselves during the political cycle at a bad time for the government, the government could try to influence the central bank’s actions. The central bank’s independence is therefore important, as it helps it to counter political pressures.

If the central bank were not independent, it could come under political pressure before an election to ease monetary policy in order to boost economic growth, reduce unemployment and thus score political points for the ruling parties. The problem is that such policy has short-term benefits but will come at the cost of higher inflation in the long run. Even worse is when this higher inflation starts to work its way into the expectations of firms, consumers and other economic agents. Once inflation is built into expectations, it is very persistent and very costly to overcome.

The understanding of independence and its institutional form changes over time and also reflects national traditions. However, the principle remains the same: to avoid short-sighted measures that will harm the economy in the long run. The following four pillars are usually considered essential for independence: functional, institutional, personal and financial independence.

Functional independence means that the central bank configures its targets independently, i.e. it decides itself what level of inflation equates to price stability, and also chooses which specific tools to use to achieve the targets (for example, monetary policy interest rates and open market operations). The CNB sets its inflation target itself, while, for example, the Bank of England’s target is determined by the government (specifically the Chancellor of the Exchequer). However, neither the CNB nor the Bank of England takes instructions from the government on how to achieve its targets.

Institutional independence means that neither the government nor any other public body can directly give instructions to the central bank – partly because this would compromise the functional independence of the central bank and could be contrary to its primary objective. The central bank’s obligations to the government and other political institutions should be reasonable. In the case of the CNB, the government and the Parliament of the Czech Republic cannot directly task the CNB, and the CNB is only obliged to inform them of its activities. The CNB has to submit to the Chamber of Deputies a report on monetary developments (currently the Monetary Policy Report) at least twice a year, and a Financial Stability Report, a Financial Market Supervision Report and a Financial Report once a year.

Personal independence means that there are precisely specified conditions in place to prevent any “informal” pressure from politicians from limiting the central bank’s functional independence. It is particularly important for the term of office of the members of the bank’s monetary policy decision-making body to be longer than the term of office of the political representation and for the grounds for dismissing the members to be precisely defined. Members of the CNB Bank Board are appointed for a six-year term and dismissed not by the government, but by the President of the Czech Republic. They can only be dismissed if they no longer fulfil the conditions required for the performance of their duties (for example, due to loss of legal capacity or loss of integrity) or if they have been guilty of serious misconduct.

Financial independence means that the central bank should (i) set and approve its own budget and (ii) not be forced to finance the government. Monetary financing, i.e. direct and indirect financing of the government by the central bank, is prohibited in most developed countries. The CNB may not finance the needs of the government of the Czech Republic or other public sector institutions and sets its own budget. It submits a report to the Chamber of Deputies once a year (in the form of a Financial Report for the past year).

The CNB is aware that independence carries with it great responsibility and has to be balanced with transparency and accountability. This is the only way to convince the public and institutions that the CNB’s independence is applied within the scope of the law and is meaningful and in line with democratic principles.

The CNB has to submit to the Chamber of Deputies a report on monetary developments (currently the Monetary Policy Report) at least twice a year, and a Financial Stability Report, a Financial Market Supervision Report and a Financial Report once a year. The CNB is also obliged to inform the public about monetary developments at least once every three months. It does so by publishing a quarterly Monetary Policy Report on its website.

However, the CNB’s transparency goes far beyond what the law requires. At the start 2008, it started to disclose the forecast-consistent interest rate path in numerical form and the votes cast by the board members on interest rate changes by name. At the beginning of 2009, the CNB also started to publish the forecast-consistent exchange rate path. Since February 2020, the CNB has been publishing attributed minutes of its monetary policy meetings, and since June 2022 it has also been publishing attributed minutes of its financial stability meetings.

High central bank transparency is additionally a natural way to influence the inflation expectations of businesses and households and anchor them to the inflation target. The CNB is a leading central bank in the field of communication and has won several awards for transparency (for example in 2015 and 2022). The public has access to all the CNB’s key documents and the decisions based on them. The CNB’s key publication is the Monetary Policy Report, which is issued quarterly and contains the CNB’s most recent economic forecast and a description of the Bank Board’s latest monetary policy decision. The forecast is described in detail, with numerical projections given for key economic indicators. Another important publication is the Annual Report, which summarises the CNB’s activities in the past year in areas including monetary policy, financial stability, financial market supervision and the issuance of banknotes and coins. In addition to these reports, the CNB issues many other regular and occasional publications.

After the end of each monetary policy meeting, a press conference is held at which the Governor (or, in the Governor’s absence, the Deputy Governor acting for him) explains the decisions taken. The minutes of the meeting, including the votes cast by the board members by name, are usually published eight days after the meeting. A full transcript of the meeting and the supporting materials for the Board’s decisions are published six years later.

In between board meetings, the board members and CNB experts provide articles and interviews to the media and give lectures and other speeches. The only exception to this openness is a media blackout starting one week before the Bank Board’s monetary policy meeting and ending with the subsequent publication of the minutes of the meeting. During this period, Board members cannot express their individual opinions on monetary policy. This is to ensure that any inconsistent communication by individual members in the period around the board meeting is not a source of undesirable market reactions.

At regular seminars held shortly after the monetary policy decision is made public, the producer of the macroeconomic forecast – the Monetary Department – presents the details of the latest forecast to commercial bank analysts and, together with a member of the Bank Board, answers their questions about the forecast and the decision. After the CZSO releases the latest inflation and GDP data, the Monetary Department provides a commentary on the new figures.