Czech Republic: Selected Issues

This Selected Issues paper analyzes inflation in the Czech Republic. The paper analyzes using an adaptive learning structural model. A structural model incorporating adaptive learning features is well suited to project inflation path in the Czech Republic. In Czechia, inflation expectations are notably shaped by past inflation outcomes, creating a feedback loop where rapidly decreasing inflation contributes to a shorter duration of elevated inflation, and vice-versa. Within this model, the central bank influences inflation through three channels. The first is direct-tightening policy reduces demand, lowers the output gap, and thus decreases inflation. The other two channels operate through inflation expectations. Tightening policy not only reduces current inflation but also impacts future expectations. Importantly, in contrast to perfect foresight-rational expectations models, the central bank can shape agents’ learning. Lower-than-expected current inflation leads to adjustments in how past inflation is perceived, influencing future inflation. The model suggests that the speed to reach the inflation target depends on the strength of the monetary policy stance.