Disinflationary Monetary Strategy and Instability of the Forward Yield Curve: The Case of the Czech Republic, 1999–2005

Abstract

In this study I describe the relationship between monetary policy and medium and long-term swap rates. I focus especially on explanation of the instability of the level and relations of swap and forward rates on the Czech swap market in the context of the Czech National Bank's (CNB) disinflation policy based on direct inflation targeting. Theoretically the main source of this problem is the inconsistency between the central bank's current and expected policy and the anticipated course of economic fundamentals. A common feature is that during disinflation the level of monetary policy restriction is not stable over time and is hard to predict for investors. Besides objective factors such as fluctuating economic growth or limited scope of information, this is also a result of the instability of sensitivity parameters of the central bank's reaction function and of the character of the monetary strategy pursued. Empirical analysis showed a limited effect of changes in the CNB repo rate on the instantaneous adaptation of swap and forward rates. In addition, problems connected with the CNB's weakened credibility were immediately identified, along with related erroneous expectations of investors. I interpret the instability of relations as evidence of differences in investors' inflation predictions of a gradual tendency for the economy to reach a state of low inflation.