On April 6th, the CNB removed the floor to CZK allowing the currency to float after 40 months of using FX intervention as a monetary policy tool. The CNB had initially instituted the floor in order to stop CZK appreciation which, according to the CNB, could have led to deflation. The CNB was successful in its use of the floor as a monetary policy tool as the Czech economy recovered to strong growth and low unemployment in 2016. However, headline inflation began to creep up early in 2017 and had reached 2.6% in March, close to the upper range of the CNB's tolerance band, led mainly by a pick-up in core prices. Given that the CNB's own inflation forecast showed inflation remaining above the 2% target, the CNB abandoned the floor which is likely to result in CZK appreciation in the short term, tightening financial conditions slightly.
So far, the impact of abandoning the floor remains limited; CZK appreciated roughly 1% against the EUR. Unlike the SNB in 2015, the CNB's decision was not a major surprise for markets that anticipated such a move after high core inflation in early 2017. Furthermore, the CZK floor has largely been an unpopular measure among Czech citizens due to higher imported service prices vis a vis holidays abroad.
In the short term, we expect CZK appreciation to continue gradually with the CNB intervening to prevent sharp FX movements. Slow appreciation of the CZK is likely to bring inflation closer to the 2% target within 12 - 18 months. The CNB is also likely to embark upon rate hikes but at a very gradual pace, probably towards June 2017 if core inflation continues to remain high. Initially hikes are likely to be in the 10 bps range in order to prevent a) sharp CZK appreciations and b) market volatility through access portfolio inflows.
All in all, the Czech economy has experienced a recovery trend and is likely currently growing above potential. The CNB's decision to abandon the peg will allow CZK appreciation with inflation returning to the CNB's target. The CNB might also hike policy rates, currently at 0.05%, gradually towards 25 - 50 bps by years end.