Czech National Bank Raises the Interest Rates for the First Time Since 2008

On Friday, August 4, the Czech National Bank made a bold move and increased the ever-static two-week repo and Lombard rates. 2W repo rate has been increased by 20 basis points, making it 0.25% with Lombard adding another 25 to 0.5%.

First, let’s look at the definitions of these rates. Two-week repo (or repossession, repurchase) rate is the discount rate at which a central bank (Czech National Bank, CNB in our case) lends money to commercial banks. Repo rate is used by monetary authorities to control monetary policy of the country – the supply and demand of the currency. These short-term loans affect the amount of money in the economy. By increasing the rate, CNB contracts the money supply to the economy and thus increases the price of money – inflation.

Lombard rate is the interest that commercial banks have to repay for making a loan from the CNB. This rate defines the upper limit for short-term money market.

May this change affect the lending or deposit rates?

Not necessarily. Although, having a low repo rate may affect the interest rates we receive when taking a loan in a bank. Lower cost of money means more money available to spend, thus lower interest. However, there are many other factors banks need to monitor that directly influence borrowing and lending. This includes credit to deposit ratio, reserve requirements etc.

Lombard and 2W repo rates are one of the three main tools that a central bank may use to regulate monetary policy, which in turn regulates inflation. As a member of the EU, the CNB target is to have an inflation rate close to 2% over the medium term. Since the start of this year, the monthly inflation rate was always higher than 2 (except for April). The forecast for the next few years shows an upward line of inflation growth.

What happens to the Czech crown

On August 3, after hearing the news, the national currency plummeted from 26.125 per Euro, to 25.965, which is a relatively big drop (according to CNB). At the end of August 7, it came back to 26.115. Let us say that the Czech crown had a little startle upon hearing the news.

In June 2017, the inflation* was 2,3%. In July 2017, 2,5 %. Czso.cz, release date: 09 August 2017.
*Inflation rate as an increase in CPI compared with the corresponding month of the preceding year.

Inflation and unemployment

Currently, the level of unemployment is low in the Czech Republic. The demand for labor by employers exceeds supply. In such a tight labor market, employers do not hesitate to offer higher wages to attract employees and contribute to rising wage inflation and potentially to rising inflation in the whole economy.

Following the fundamental principles of supply and demand, inflation tends to be low when unemployment is high, and vice versa.

This relationship is however more complicated than it appears at first glance. The predictions based on negative correlation between inflation and unemployment have turned out to be wrong on a number of occasions over the past decades.

In July 2017, the unemployment rate in the Czech Republic was 4,1%.

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