The Czech Economy and Monetary Policy:
Deflationary Risks and
the Exchange Rate as a Monetary Policy
Instrument
Luboš Komárek
75th East Jour Fixe - 10 Years of EU Enlargement
Vienna, 25th April 2014
2
I. Did the flexible exchange rate regime help to keep
the economy competitive in the boom years?
3
1. A small open economy with a flexible exchange rate regime like the Czech Republic
must always bear in mind that:
• the exchange rate could behave either as a shock absorber or as a shocks generator
(source of shocks).
• a flexible exchange rate in a (post)-transition economy can also serve as a channel of
nominal convergence towards the advance economies.
2. The Czech Republic introduced the flexible exchange rate in May 1997 as a reaction on
exchange rate turbulences. Since then we observed an appreciation trend until the
financial crisis of 2008.
• The appreciation trend was in line with the nominal convergence of the Czech
economy when domestic inflation remained at low levels and well anchored. The
exchange rate thus served as a tool against overheating of the booming economy.
3. Overall, the flexible exchange rate regime had stabilizing effect on the economy and
minor fluctuations were absorbed in exporters’ profit margins. However, in 2002 and in
2007, we saw abrupt appreciation of the Czech Koruna. Because these swings could
endanger the competitiveness of the economy, the CNB reacted.
I. Did the flexible exchange rate regime help to keep the economy
competitive in the boom years?
4
• In 2002, appreciation was caused by huge capital inflow (seen as an external factor, i.e.
shock to the economy). The CNB lowered the interest rates and additional measures were
also implemented (e.g. sterilization of privatization FDI). This helped to ease monetary
conditions.
• In 2007, possible carry trade operations were probably behind the Koruna depreciation in
the first half of the year. In these times the Czech Republic had lower interest rates
compared to the euro area. Beginning of the global financial crisis led to selling out of risk
assets and subsequently to repayments of loans in Koruna which served as a financing
currency. This caused an abrupt appreciation of the Koruna.
• When the Czech economy was hit by the global financial crises in 2009, the Koruna
weakened and helped thus to ease monetary conditions while the external demand
slumped.
• Since the global financial crises the Koruna has been moreover flat until the CNB used the
exchange rate as the tool of monetary policy from 7th November 2013.
• Later, the experience of the Czech Republic shows the advantage of having additional
monetary instrument in ZLB constraint situation, which the CNB reached in November
2012.
I. Did the flexible exchange rate regime help to keep the economy
competitive in the boom years?
5
CNB interventions / ER as the tool of monetary policy
• Sales of FX reserves yields were halted in November 2012 in order to avoid the possible
conflict of monetary policy implementation in case of commencement of FX intervention to
weaken the CZK/EUR exchange rate.
• 7th November 2013: the CNB decided to switch to an alternative scenario and start using
the exchange rate as an instrument for further monetary easing ⇒ CNB´s commitment to
hold the exchange rate close to 27 CZK/EUR level (at least to beginning 2015)
7499 mil.EUR
-150
0
150
300
450
600
750
900
1050
1200
22
24
26
28
30
32
34
36
38
40
1/98 1/99 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 1/11 1/12 1/13 1/14
mil.
EU
R
intervention sale of forex reserves yieldsbuy-up from Privatisation Account to forex reserves CZK/EUR
3560 mil. EUR
Comparison of model scenarios (Board meeting
on 7th November 2013)
6
• The relevant policy comparison was between the alternative scenario with exchange
rate instrument and the passive MP scenario(s) – here the difference clearly favours
the former in all major variables (plus recall the uncertainty as regards the return to the
target with passive MP).
-1
0
1
2
3
4
I/12 III I/13 III I/14 III I/15 III
Headline inflation (y/y in %)
-0,6
-0,4
-0,2
0,0
0,2
0,4
0,6
0,8
1,0
1,2
1,4
I/12 III I/13 III I/14 III I/15 III
3M PRIBOR (in %)
-3
-2
-1
0
1
2
3
4
5
I/12 III I/13 III I/14 III I/15 III
Baseline scenarioPassive MPPassive MP +ER shockAlternative scenario
GDP (y/y in %)
-1
0
1
2
3
4
I/12 III I/13 III I/14 III I/15 III
MP-relevant inflation (y/y in %)
7
2W repo rate path – Comparison of all scenarios
(Board meeting on 7th November 2013)
• The alternative scenario assumes exit in 1.Q 2015, but it might come later in reality (the
Board may take a different view, premature exit must be avoided, the ER pass through
might prove weaker, economic situation may change etc.).
8
II. Currently, the Czech Republic experiences very low
inflation. How do you deal with this situation?
9
• Historically, inflation in 2013 was at very low levels. In the last fifteen years, a similar
reduction in inflation occurred at the turn of 2002/2003.
• 2013: (i) clear decline in wage growth in the business sector, (ii) weak effective foreign
demand, (iii) effect of domestic restrictive fiscal policy and (iv) stronger exchange rate.
• The only Inflation component with a growth outlook was food prices, mainly due to the
trend growth of agricultural commodity prices on world markets in recent years, but with a
distinct slowdown in prices expected in late 2013 and 2014 also.
II. Currently, the Czech Republic experiences very low inflation.
How do you deal with this situation?
-10
-5
0
5
10
15
20
25
30
35
1998Q1 2000Q1 2002Q1 2004Q1 2006Q1 2008Q1 2010Q1 2012Q1 2014Q1
Total CPI MP inflation
Net inflation (excluding tax changes) Regulated prices (including tax changes)
Regulated prices (excluding tax changes)
10
• The CNB restricting monetary policy given by the lower limit of zero policy rates (base
rate 2W repo was set since late 2012 on the technical zero). ⇒ Risk of deflation at least
in the first half of 2014.
• The deflationary risk was also amplified the potential appreciation of the koruna due to
higher domestic real interest rates coupled with the expected recovery of the economy 's
main trading partners in a situation of relaxed monetary policy in the world and the gradual
unwinding of domestic government measures in the fiscal area.
• The published data thus confirm the CNB's view that the November decision to start using
the exchange rate as an additional instrument of monetary policy contributed significantly
to ward off the threat of deflation.
• Outcomes of the weakening of the exchange rate (up to now):
(i) higher import prices ⇒ higher consumer prices
(ii) higher net nominal exports ⇒ higher GDP growth
(iii) higher inflation expectation ⇒ higher domestic consumption
II. Currently, the Czech Republic experiences very low inflation.
How do you deal with this situation?
11
Inflation expectations
Outlook for 12 and 36 months
12
Headline inflation forecast (Inflation Report I/2014)
-1
0
1
2
3
4
5
6
I/12 II III IV I/13 II III IV I/14 II III IV I/15 II III
90% 70% 50% 30% confidence interval
Inflation target
Monetary policy
horizon
13
GDP growt forecast (Inflation Report I/2014)
-4
-2
0
2
4
6
8
10
I/12 II III IV I/13 II III IV I/14 II III IV I/15 II III
90% 70% 50% 30% confidence interval
Conclusion
14
• Before November 2013 the Czech National Bank (CNB) used its standard
instruments to ease the monetary conditions. The key monetary policy
rate was lowered gradually and reached the technical zero bound in
autumn 2012.
• In order to avoid long-term undershooting of the inflation target and to
speed up the return to the situation in which it will be able to use its
standard instrument, i.e. interest rates, the CNB has started to use the
exchange rate as an additional monetary policy instrument.
• The CNB is resolved to intervene on the FX market in such volumes and
for such duration as needed to reach the desired exchange rate level with
the aim of hitting its inflation target in the future.
Reaction of international institutions
IMF and OECD statements about interventions
•“Fund advice, at the last Article IV Consultation, was that if a persistent and large
undershooting of the inflation target is in prospect, FX interventions should be employed.
The current situation justifies the CNB’s action from that perspective.” - Mr. Masanori
Yoshida, Mission Chief for Czech Republic, International Monetary Fund.
•‘If a persistent and large undershooting of the inflation target is in prospect, additional
tools should be employed. Foreign exchange (FX) interventions would be an effective
and appropriate tool to address deflationary risks in the context of inflation targeting
framework. …..‘ Mr. Johann Prader, the Executive Director representing Czech Republic
in the Executive Board of the International Monetary Fund.
•„Low demandside pressures and decelerating food prices are containing inflation
pressures in the near term. With interest rates technically at zero and excess liquidity in
the banking sector, the National Bank has started foreign exchange interventions to
prevent a long-term undershooting of the inflation target. Foreign exchange interventions
should continue until inflation rises into the boundaries of the inflation target range and
conventional monetary policy tools become effective again,“ - Organisation for
Economic Co-operation and Development.
Thank you for your attention!
www.cnb.cz
Luboš Komárek
Director
External Economic Relations Division
Monetary and Statistics Department
17
-40
-35
-30
-25
-20
-15
-10
-5
0
5
10
15
20
1/91 1/92 1/93 1/94 1/95 1/96 1/97 1/98 1/99 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 1/11 1/12 1/13 1/14
depreciation
appreciation
targeting of M2 and untilMay 26, 1997 ER as well inflation targeting
band +/-0,5%Sep 27. 1992 - Feb 2.1996
the level of ER against the former
currency basket(65% DEM, 35% USD)
band +/-7,5%Feb 28.1996 - May 27.1997
The exchange rate development (1991-2014)
18
Real GDP growth (s.a., y/y in %)
• The Czech economic cycle has become synchronized with
the euro area, with a double-dip pattern
-6
-4
-2
0
2
4
6
819
9919
9920
0020
0120
0120
0220
0320
0320
0420
0520
0520
0620
0720
0720
0820
0920
0920
1020
1120
1120
1220
13
Czech Republic eurozone
II. Currently, the Czech Republic experiences very low inflation.
How do you deal with this situation?
19
CZK/EUR Nominal exchange rate development
• After the notification of the CNB´s Bank Board at a press conference on 7th November
2013 to initiate FX interventions and to use the exchange rate for the further easing of
monetary policy, the exchange rate immediately depreciated to the desired level of 27
CZK/EUR
24,0
24,5
25,0
25,5
26,0
26,5
27,0
27,5
28,0
01/1
2
02/1
203
/12
04/1
205
/12
06/1
207
/12
08/1
2
09/1
210
/12
11/1
212
/12
01/1
3
02/1
303
/13
04/1
305
/13
06/1
307
/13
08/1
3
09/1
310
/13
11/1
312
/13
01/1
4
02/1
4
Communication of the CNB´s Bank Board regarding the possibility of monetary easing through the weakening of the exchange rate
CNB´s commitment to hold the exchange rate close to 27 CZK/EUR level
FX intervention (7 November 2013)
…but the effect of verbal intervention gradually began tofade
20
Structure of the Czech GDP growth
• Post-Lehman decline mainly due to falling inventories and fixed
investments, recently private consumption as well
• The main driver of Czech GDP growth has been net exports
Annual GDP growth structure(annual percentage changes; contributions in percentage points; seasonally adjusted)
-8
-6
-4
-2
0
2
4
6
8
I/07 I/08 I/09 I/10 I/11 I/12 I/13
Household consumption Net exportsGross fixed capital formation Government consumptionChange in inventories GDP growth
21
Fo
reign
trade
of g
oo
ds an
d services in
2012(%
of
GD
P)
0 10 20 30 40 50 60 70 80 90100
SlovakiaHungary
NetherlandsLithuaniaMalaysia
Czech RepublicBulgaria
SerbiaGermany
PolandCroatia
RomaniaZambia
PhilippinesCanada
South AfricaNew Zealand
GreeceUgandaTurkey
IndiaRussian Federation
Indonesia
22
Economic openness of the Czech Republic
• High and increasing openness to foreign trade
• The level of exports is very closely linked to imports
0
10
20
30
40
50
60
70
80
90
100
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Exports of G&S (% of GDP) Imports of G&S (% of GDP)
23
Foreign trade (y/y in %, s.a.)
• Sharp drop in foreign demand in post-Lehman period
• After the financial crisis export growth has slowed down
gradually, exports mainly directed to the core euro area
-20
-15
-10
-5
0
5
10
15
20
25
06/I III 07/I III 08/I III 09/I III 10/I III 11/I III 12/I III 13/I III
Real exports Real imports
24
Output gap (in % of potential output)
• Some overheating before the crisis
• Negative output gap since early-2009 (Kalman filter),
currently remains significantly negative
-6
-4
-2
0
2
4
6
8
I/06 I/07 I/08 I/09 I/10 I/11 I/12 I/13
HP filter Kalman filter Production function
25
Inflation targets
0
1
2
3
4
5
6
7
8
12/97 12/98 12/99 12/00 12/01 12/02 12/03 12/04 12/05 12/06 12/07 12/08 12/09 12/10 12/11
point target of 3 % announced in March 2004
target 1998 6% +/- 0,5p.b.(set in Dec 97)
target 1999 4,5 +/- 0,5p.b.(set in Nov 98)
target 2000 4,5 +/- 1p.b.
(set in Dec 97)
target 2001 3% +/- 1p.b.(set in Apr 00)
start of thetarget band3 - 5 % target band
2002-2005(set in April 01) end of the
target band2 - 4 %
point target of 2 % announced in March 2007
• Currently a 2% target (since January 2010)
26
Achievement of targets
• Since 1997-1998 (CZK depreciation, deregulations) gradual
disinflation process, low inflation since 1999
• Inflation has been volatile due to commodity price shocks and
changes in indirect taxes and administered prices
-1
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
1/98 1/99 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 1/11 1/12 1/13 1/14
headline inflation
net inflation
start of targetband 3 - 5 %
target band 2002-2005( announced 4/2001)
end of target band 2 - 4 %
target 1998 6% +/- 0,5p.p.
target1999 4,5 +/-
target 2000 4,5 +/- 1p.p.
target 2001 3% +/- 1p.p.
point target 3%(announced 3/2004)
target 2005 2%+/- 1 p.p.announced 4/1999)
point target 2%(announced 3/2007)
27• Process of disinflation led to their fall to historically low levels
Monetary policy during crisis
CNB key interest rates (percentages)
0
2
4
6
8
10
12
14
16
18
201/
93
1/94
1/95
1/96
1/97
1/98
1/99
1/00
1/01
1/02
1/03
1/04
1/05
1/06
1/07
1/08
1/09
1/10
1/11
1/12
2013
2014
1W repo rate and 1W PRIBOR 75%,
the Lombard rate 50%in May 1997
the Lombard rate
discount rate
2W repo
1W PRIBOR
28
• Monetary policy easing in 2008-2010, 2W Repo rate cut from 3.75% to 0.75%, three further rate cuts in 2012
• Main policy rate currently at the „technical“ zero lower bound level 0.05%
Monetary policy during crisis
CNB key interest rates (percentages)
0
1
2
3
4
5
1/07 1/08 1/09 1/10 1/11 1/12 1/13 1/14
Lombard rate 2W repo rate Discount rate
