Monetary Policy and Exchange Rate Commitment in the Czech Republic
- International Monetary Fund
- Published Date:
- May 2017
I would like to thank the Bank of Albania for inviting me to this conference, for the excellent organization and the very interesting content of this conference.
This morning, I will talk about the monetary policy experience of the Czech Republic and the influence and spillovers of our policy.
My presentation will be about the experience of the Czech National Bank (CNB) with the exchange rate as a further monetary policy instrument within the inflation target regime. I will start with the situation and the conditions for the implementation of this new tool, then evaluate its effects, and later I will discuss the exit from the exchange rate commitment, which actually happened quite recently.
2. The Context
On the charts shown in Figure 1, you see depicted the economic situation we faced in November 2013, when the Czech economy was going through the longest recession in its history. As shown in the right chart, we had negative growth rates and a sluggish growth outlook. This was influenced by subdued external demand as well as by fiscal policy consolidation. The inflation outlook was also gloomy. By the end of 2012, the interest rates were at the zero lower bound, and for the CNB, this bound was really binding. It was an effective lower bound at that time because we were facing some legal barriers to lowering interest rates to negative territory. It would have had negative consequences for the legal framework in the Czech Republic, and there was also a concern about its effectiveness because we would have expected cash hoarding and deposit outflows had interest rates been lowered below zero.
Figure 1.Context for implementation of FX commitment
So, on the left hand side chart, you can see the inflation forecast at that point in time was conditional on two possible monetary policy options. Without monetary policy actions, we would have experienced deflation, with the inflation rate falling significantly below zero. The two policy options behind the forecasts were: (1) decreasing interest rates into negative territory, which the model was able to accomodate (unlike us in reality); and (2) the alternative tool, which was chosen, that is the exchange rate commitment.
You can see from Figure 1 that with the exchange rate commitment, we were forecasting inflation to revert to target within the monetary policy horizon, followed by a degree of overshooting for some time.
So what was the foreign exchange commitment of the CNB? The CNB introduced the exchange rate commitment in its policy meeting held in November 2013; it was an asymmetric commitment to maintain the Czech koruna exchange rate toward the euro at or above 27 korunas per euro.
On the weaker side, the CNB would let it fluctuate above the floor, but it would not let it appreciate below the floor. The main purpose of this floor was really to avoid deflation and long-time undershooting of the inflation target. Developments in the real economy of the Czech Republic motivated the adoption of this policy option. This is, therefore, slightly different from the motivations in Switzerland.
The exchange rate was used as an additional tool within the framework of inflation targeting. We remained inflation targeters; we didn’t want to change the monetary policy regime. As we were at the zero lower bound, we had to think of additional tools to ease monetary policy conditions to prevent the negative consequences for the Czech economy, which would have resulted from a widening output gap and a disanchoring of inflation expectations.
All in all, the CNB commitment lasted for three years and five months and it ended on April 6, 2017, just one month ago. You can see how the exchange rate developed during the commitment in Figure 2. The exchange rate adjusted quite fast, immediately after the introduction of the exchange rate commitment. It even remained above the floor for more than one year. Hence, there was no need for the Czech National Bank to intervene in the financial markets, except for the first days, as shown by the blue bars in the chart of Figure 2. Initial interventions necessary to enforce the commitment actually saved any further interventions, as the market had confidence in the CNB’s willingness and ability to enforce the commitment.
Figure 2.The CNB FX commitment
Interventions resumed in May 2015. Appreciation pressures re-emerged as a result of speculation about the timing of a possible exit from the exchange rate commitment, which also fueled FX hedging from exporters, and the initial effects of further ECB monetary policy accommodation, which stimulated further capital inflows.
The intervention activity intensified in the second half of 2016 and the beginning of 2017, as the financial markets perceived that the inflation outlook was improving and they were speculating that the CNB could terminate its foreign exchange commitment any time soon. Thus, there was a lot of speculation on suspected exchange appreciation after the upcoming exit from the foreign exchange commitment regime.
All in all, the interventions amounted to EUR 56 billion up to February 2017; these are the last published data. But we already know that by the end of March 2017, almost at the end of the exchange rate commitment, the foreign exchange reserve of the Czech National Bank increased to 70 percent of GDP. Therefore, in this period, we accumulated a sizeable amount of FX reserves.
The length of the exchange rate commitment was initially not stated, but it was almost immediately obvious that it was important to give the real economy some kind of guidance on the length or duration of the exchange rate commitment. Therefore, the CNB bank board started to guide markets and say what was the expected minimum duration of the foreign exchange commitment. This was called in our slang the “hard” commitment, which was really perceived as an almost irrevocable commitment of the CNB to keep the exchange rate commitment for the minimum period indicated. This is shown in Figure 3. These are the red bars in the figure, and you can see they appeared almost immediately after the entry of the foreign exchange rate commitment into effect.
Figure 3.Prolongation of FX commitment
The duration was initially stated to last until the end of 2014. Then, after eight months, it was prolonged to the end of 2015, and then it was prolonged three times, again and finally, in September 2016, when it was prolonged until March 2017. The gray bars in the chart of Figure 3 show the assumption of the CNB official economic forecast. The economic forecast had to work with some assumptions about how the monetary policy would work to facilitate a gradual return of inflation to target. Therefore, you can see that these forecast assumptions more or less coincided with what the bank board externally communicated.
The prolongations of the exchange rate commitment were driven by the repeated disinflationary surprises or shocks, which we were all facing in Europe with declining producer prices. These shocks led to multiple revisions in the pace and timing of convergence of inflation to target. All forecasters in Europe were facing the same issues: the inflation rates were depressed, there were downward revisions in the inflation forecasts, and subdued underlying inflation pressures. As the Czech economy “imports” a lot of inflation from Europe, this was also the problem of the Czech economy, but we can say that deflation risks in the Czech Republic were averted.
4. Effects of the Exchange Rate Commitment
We tried to evaluate the effects of the exchange rate commitment in the Czech economy. The estimated effects on economic growth are in the first line of the table shown in Figure 4. We can see that in 2014 – the first year after the introduction of the commitment – the economic growth was 2.7 percent. We were facing some positive contributions from growth in the euro area, about 1 percentage point, but a real significant contribution, almost 2 percentage points, was estimated due to monetary policy and its effects on the economy. In the same table, you can also see that there is an effect of fiscal policy on GDP growth amount, for example, to 1 percentage point in 2013.
Figure 4.Effects of the exchange rate commitment on Czech economy
In the international context, the most important effects from the ECB monetary policy on the Czech monetary policy were the interest rate differential, as well as capital and liquidity flows from the euro area, as a consequence of the large supply of liquidity and the lower yields of financial assets. In Figure 5, you can see the length of the exchange rate commitment in the context of ECB asset purchase programs. What the CNB faced was the inflow of money from international investors, who were searching for yield. There was interest rate differential on Czech assets, though government bond yields in the Czech Republic also went deeply negative. We had negative yields up to six years of maturity, and there was important speculations also on the appreciation of the currency.
Figure 5.International context – financial markets
The intervention activity of the Czech National Bank was influenced by this and also naturally by the inflow of the money from real economy activities from net exports, and also from hedging activity of the exporters.
The CNB has always repeated that the intervention and its balance-sheet consequences are not important because the primary objective of the CNB is to achieve the inflation target, and the profit consequences, which will come later, are secondary to this goal.
5. The Exit
What about the exit? The exit came when the economic conditions – which were stipulated before – were met: this was a sustainable fulfillment of the 2 percent inflation target. Inflation has reached 2 percent already before the end of 2016, and during the first months of 2017 we are above 2 percent. This is partially the result of some transitory, one-off effects including the effect of oil price developments, some administrative effects, and also the development of food prices, but we are pretty confident about the robustness of inflationary developments because core inflation in Czech Republic is comfortably at 2 percent and inflation pressures in the domestic economy are quite strong and robust.
The exit from the exchange rate commitment took place as a transparent one-off termination: at a regular meeting of the bank board, which was initially not scheduled as a monetary policy meeting, but turned into a monetary policy meeting. This meeting was the first meeting of the bank board after the end of commitment at the end of March 2017. It was said that the managed float regime would be employed, but the CNB would be ready to observe or manage large volatility that might come. It was not specified what kind of volatility this was going to be, because some volatility was to be expected; we would only go to market if volatility was excessive.
What actually happened is depicted on the chart of Figure 6. You can see that there was some appreciation, but it was really mild, less than 2 percent at the maximum and now the exchange rate is even weaker again.
Figure 6.Exit from the FX commitment
The data in the chart are until Friday on April 28, 2007. At that point, we are at around 26.8 CZK/EUR, so still slightly below the 27 CZK/EUR former floor, as shown on the chart. No massive appreciation took place. It was not expected by us, for several reasons. We thought that a weaker exchange rate would transmit to nominal variables so there would be less pressure to appreciate and also that the real equilibrium appreciation would be slower than before the economic crisis: about 1 to 2 percentage points per year.
An important consideration was that there were large speculative positions built in Czech koruna and that investors were actually waiting to realize their profits from their positions. These investors would take any profitable opportunity to go out of Czech currency. They would, hence, provide depreciation pressures that would limit the appreciation tendency.
In summary, the Czech National Bank has successfully used exchange rate as a monetary policy tool, and we kept our inflation target regime. We averted the risk of deflation. Because of repeated anti-inflationary shocks, we had to prolong the exchange rate commitment several times. It was finally terminated after three and a half years, but the exit has been so far quite smooth, and no excessive FX volatility has so far appeared. In 2017, our outlook is for a sustainable fulfillment of the inflation target. Our most recent inflation outlook indicates some overshooting of the point inflation target of 2 percent in the coming year, but we are going to be around 2.6 – 2.7 percent, and go back to the inflation target within the monetary policy horizon in 2018.