4. How the CNB’s interest rates affect the Czech economy
The Czech National Bank sets monetary policy mainly by means of three monetary policy interest rates. Its key rate is the two-week (2W) repo rate. Its other two interest rates – the Lombard rate and the discount rate – are linked to the repo rate. A change in the CNB’s interest rates subsequently passes through to market interest rates, through which it affects many other economic variables and, with a lag, influences prices of goods and services and, in turn, inflation.
Interest rates are the CNB’s main monetary policy instrument. The Bank Board decides on their levels at its monetary policy meetings. The rates are announced on the CNB website after the end of each meeting. How future inflation is influenced by the changes made to interest rates is described by the “transmission mechanism”. The first step in the transmission mechanism is the pass-through of monetary policy rates to financial market rates. This is achieved in practice through repo operations, which are remunerated at the two-week (2W) repo rate. “Repo” is short for “repurchase agreement”. As there has long been a liquidity surplus in the Czech economy, the CNB withdraws liquidity in its repo operations. Liquidity-absorbing repos involve the central bank selling securities to banks and buying them back later at a higher price. The resulting return for the counterparty (the lending commercial bank) corresponds to the 2W repo rate. Owing to competition on the interbank market, short-term market rates adjust to monetary policy rates and monetary conditions tighten or ease. Market rates (and other market variables such as the exchange rate) often adjust even before the CNB’s monetary policy rates change, as the market usually anticipates the change.
Changes in the 2W repo rate are reflected almost immediately in the 3M PRIBOR, which is the benchmark three-month interbank market rate. In addition to the current price of money, long-term market interest rates are affected by factors such as the future path of short-term rates, the level of foreign interest rates and the risk associated with long-term lending. Long-term market rates do not fully copy short-term monetary policy rates, but do largely reflect them and tend to move in the same direction when monetary policy rates change. In the chart below, the benchmark five-year interest rate swap (5Y IRS) shows the rate at which banks are willing to borrow money for the next five years at a given point in time. Among other things, mortgage rates are derived from this rate.
Chart – How changes in the 2W repo rate pass through to market rates (2017–2024)
Monetary policy affects inflation through several different pathways, referred to as transmission channels. While these channels work in parallel, they affect the economy to different degrees and with different lags. The interest rate and exchange rate channels play the main role in a small open economy like the Czech Republic. In both these channels, a change in interest rates affects inflation in the same direction – a rate hike reduces future inflation and a rate cut increases it, other things being equal.
The interest rate channel works because monetary policy interest rates are linked to market rates on the interbank market and to the client rates of banks and other financial institutions. If the CNB raises its interest rates, loan and deposit rates go up gradually as well. At higher rates, households save more and borrow less, and therefore buy less. Firms meanwhile face higher interest costs and thus curb their investment spending. Economic growth slows, wage growth decelerates and inflation ultimately goes down.
Through the exchange rate channel, a change in domestic interest rates affects the exchange rate of the koruna, which in turn affects prices of imported goods and, with a lag, the competitiveness of Czech producers. This is reflected in inflation. The exchange rate channel is a very significant transmission channel in a small open economy like the Czech Republic.
Besides these main channels, monetary policy affects future inflation via the inflation expectations of households and firms. Through its actions and communications, a credible central bank consistently shows that despite temporary fluctuations, inflation will return to the target.
The interest rate channel acts directly through the behaviour of firms and households. If central bank interest rates and, subsequently, interbank market rates increase, client loan and deposit rates go up gradually as well. At higher rates, households save more and borrow less, and therefore buy less. They are better off postponing part of their consumption. Demand for goods and services thus decreases. This is reflected in lower inflation. Firms meanwhile face higher interest costs and thus curb their investment spending.
In addition, banks more rigorously assess the riskiness of their customers and increase their risk premia. This reduces the availability of new loans in domestic currency. The decline in households’ consumer demand and firms’ investment expenditure causes production in the economy as a whole to decline. Economic growth slows, wage growth decelerates, the labour market cools and inflation ultimately goes down.
Through the exchange rate channel, a change in domestic interest rates affects the koruna exchange rate, which in turn affects prices of imported goods and, with a lag, the competitiveness of Czech producers. This is reflected in inflation. If domestic interest rates go up, for example, the rising return on koruna assets relative to foreign currency assets (due to the domestic rate being higher than foreign rates) induces increased demand for the domestic currency and hence appreciation of the koruna.
The domestic currency usually strengthens (appreciates) immediately after the repo rate is raised. If the change is expected (for example, due to very similar communications from Bank Board members), the domestic currency appreciates even before the repo rate is increased. The stronger domestic currency leads to a decline in prices of imported consumer goods and intermediate goods. This is gradually reflected in slower growth in domestic consumer prices (lower inflation).
The appreciation of the domestic currency also leads (with a rather larger lag) to a deterioration in domestic producers’ competitiveness and a decline in demand for their production due to a rise in the price of domestic goods relative to foreign goods. Domestic production thus goes down, employment falls and wage growth slows. This puts further downward pressure on inflation. A depreciation of the domestic currency has the opposite effect. The exchange rate channel is a significant transmission channel in a small open economy like the Czech Republic.
The asset price channel acts through changes in the pricing of financial and non-financial assets such as securities (e.g. bonds and shares) and real property. Other things being equal, a rise in interest rates causes asset prices to fall, because the higher interest rates reduce the expected rate of return. Assets therefore become less attractive than better-remunerated – and safe – bank deposits. This dampens firms’ investment activity. A fall in current market asset prices also represents a decline in households’ perceived wealth. This will be reflected in a reduction in their consumption. Overall, this leads to slower growth in economic activity due to lower demand, and thus again reins in inflation.
Monetary policy also affects future inflation via the inflation expectations of households, firms and financial markets. The inflation expectations of economic agents fundamentally affect their decision-making and thus influence the overall economic situation and the resulting inflation rate. This is particularly important in the case of an inflation-targeting central bank such as the CNB. Expectations can be largely self-fulfilling. Through its actions and communications, a credible central bank consistently shows that despite temporary fluctuations, inflation will return to the target. Steering households’ and firms’ expectations in this way is essential for monetary policy to be successful in the long term. For the central bank to maintain its credibility, it must not delay if there is a significant danger of inflation deviating from the target. It must use the tools available to it to fulfil its mandate, return inflation to the target and keep inflation expectations anchored.
A change in interest rates affects the economy, including inflation, through the transmission channels described above. However, none of them operates instantly. For each of them, it takes time for a change in interest rates to pass through fully to goods and services prices. While the exchange rate channel affects the economy relatively quickly, the interest rate channel, which acts via demand in the economy, has a lag of one to two years.
As interest rate changes affect the economy with a considerable lag, the CNB’s monetary policy has to be forward-looking and its decision-making must focus on the future period in which the change in monetary policy will have the greatest effect. This period is called the monetary policy horizon. In the CNB’s case, the monetary policy horizon is roughly 12–18 months ahead. In order to be able to react today to any inflation risk in this period, i.e. at the monetary policy horizon, the CNB draws up a forecast of future developments in the Czech economy. The CNB forecast is the key input to the Bank Board’s decision-making on the appropriate monetary policy stance.
The total effect of interest rate changes on inflation is the sum of the effects of the individual transmission channels. For each channel, it takes time – often a different time – for a change in interest rates to pass through fully to goods and services prices. The current state and structure of the economy also plays a significant role in the length and strength of the transmission channels. In the economic literature, simulations of macroeconomic models are usually used to quantify the magnitude and timing of the effects of interest rate changes on economic and price developments. The exchange rate channel is the fastest transmission channel in the Czech economy (and in open economies generally). This may be because of the immediate change in the interest rate differential vis-à-vis the rest of the world. The transmission of a change in monetary policy interest rates to inflation via the interest rate channel is delayed due to inertia in households’ consumer habits and firms’ demand for labour and capital. Households and firms thus adapt at a slower pace. The resulting impact on inflation therefore peaks with a lag.
Changes in monetary policy interest rates affect inflation with a considerable lag. This means that monetary policy has to be forward-looking and the CNB must focus on the future, not the present, in its decision-making. The future period in which changes in monetary policy rates have the greatest effect on inflation is called the monetary policy horizon. In the CNB’s case, the monetary policy horizon is roughly 12–18 months ahead, although the optimal horizon may differ depending on whether inflation is of a cost or demand nature. With its current decisions to change monetary policy rates, the CNB thus affects inflation in the Czech Republic in more than one year’s time. Each inflation-targeting central bank sets its monetary policy horizon according to the length of transmission and the specifics of the local economy. Monetary policy horizons therefore differ across central banks. Many central banks only set them in qualitative terms, for instance as a medium-term horizon.
As the CNB’s current monetary policy decisions affect inflation most strongly at a monetary policy horizon 12–18 months ahead, analytical documents are needed to show the most likely future economic developments and thus enable the Bank Board to make responsible monetary policy rate decisions. One such comprehensive document is the CNB forecast, which is based on projections from the core g3+ model but also takes into account other economic indicators and the expert opinions of Monetary Department economists. The CNB forecast is drawn up four times a year and is published in the Monetary Policy Report. The latter is used both by the CNB Bank Board when deciding on monetary policy rates and by the public for obtaining information about the most likely future economic developments.