Monetary policy of the Czech National Bank
Principles, procedures, instruments
Would you like to know a bit more about the Czech National Bank than what you can find in the newspapers? The following fact sheet will guide you around the world of the CNB. It’s a world that may seem unremarkable, but the CNB’s work is in many respects crucial to the Czech economy.
According to the Czech Constitution, the CNB’s primary objective is “to maintain price stability”. Without prejudice to this primary objective, the Czech National Bank is also tasked with supporting the “general economic policies of the Government leading to sustainable economic growth”. This means that the CNB should set its main policy instrument, namely interest rates, at a level that will maintain inflation at a low and stable level without needlessly slowing or excessively accelerating, the economic growth rate.
High inflation damages the economy
The objective of achieving and maintaining low and stable inflation is based on international experience that high and volatile inflation damages the economy. It causes this damage by creating uncertainty and forcing money holders to focus on short-term projects. Economic growth, meanwhile, is founded primarily on longer-term investment. High inflation also hampers inflation forecasting and thus introduces various distortions into the economy: it changes the real value of debtors’ liabilities to their creditors, creates distortions in the tax system, causes interest rates to be volatile (leading in turn to swings in the inflow and outflow of short-term risk capital and hence to exchange rate fluctuations), and so on. Savers are also often unaware that high inflation erodes the value of their savings.
The economic value of low inflation is also demonstrated by the fact that maintaining inflation at low levels is currently the primary objective of central banks in the majority of the advanced nations, including the European Central Bank.
The CNB is an independent and open institution
In the pursuit of its statutory objective, the CNB has a high degree of independence from political influence. Above all, it is independent in making decisions on the settings of monetary policy instruments. Its independence is also reflected in the manner in which its senior officers are elected and dismissed (they are appointed and – under very strict conditions – dismissed by the Czech President).
The CNB’s independence protects it primarily from any political pressure to adopt measures to boost short-term economic growth, for instance in the run-up to a general election. Such measures would in the longer term cause an undesirable rise in inflation, while growth in economic activity would soon return to its original level, or even fall below it (as a result of the increased inflation).
The CNB’s high degree of independence is counterbalanced by openness with respect to disclosure of information. The CNB uses various channels to inform the public about its monetary policy system, its inflation target, its inflation forecasts and the attendant risks, and about its monetary policy measures and its reasons for adopting them. To inform the public, the CNB not only issues quarterly Inflation Reports, which are submitted to the Chamber of Deputies (the lower house of the Czech Parliament) and published on the CNB’s website, but also releases minutes of the CNB Bank Board’s monetary policy meetings, holds news conferences, publishes articles and gives interviews in the press and other media, arranges presentations and speeches by Bank Board members, and so on.
The CNB steers inflation towards the official inflation target
Since January 1998, the CNB has conducted its monetary policy within an inflation targeting system. Putting it simply, the CNB has undertaken to try to maintain inflation under normal external economic conditions on course for an announced inflation target. This system has some significant advantages over other monetary policy regimes (such as money targeting and exchange rate targeting). First of all, it focuses directly on controlling inflation, a variable that directly affects the decision-making
and behaviour of most of us in the areas of consumption, investment and saving, even though we may not realise it. This central bank commitment in the form of an inflation target is generally intelligible to the public and provides an anchor for inflation expectations. Figure 1 illustrates inflation targets since the start of inflation targeting in the Czech Republic.
Figure 1: The CNB's inflation targets
Monetary policy needs to be forward-looking
Owing to the lag that arises between the implementation of a monetary policy measure and its greatest impact on inflation, the
CNB’s monetary policy decision-making is guided not by the present situation but by the forecast for the future – rather like someone deciding what to put on when leaving home in the morning not according to the weather outside but according to the forecast for the whole day. By the CNB’s estimates, interest rate changes have their greatest impact on inflation some 12 to 18 months further down the line. Consequently, the CNB concentrates on this horizon in its monetary policy deliberations, although of course it also takes into account developments before and after this period.
The forecasts for inflation and the economy as a whole are based on past and present developments, on assumptions regarding several key variables. The forecast is created using a sophisticated model of the workings of the Czech economy. However, it is also significantly affected by the professional discussions and expert opinions of CNB economists.
The prediction model is based on the CNB’s knowledge of how strongly – and with what kind of lag – developments in the external environment (such as changes in inflation or economic growth in other countries and world prices of raw materials), price-related administrative decisions made by Czech state and local authorities, and, in particular, changes to the CNB’s interest rates, pass through into various areas of the economy and ultimately into inflation. The two most important channels whereby changes to the CNB’s rates affect the economy run via client interest rates and via the Exchange rate. Client interest rates, i.e. the lending and deposit rates that commercial banks offer to households and firms, move in step with changes in the CNB’s rates. Client interest rates in turn affect demand – i.e. how much households consume and firms invest and, conversely, how much both groups save. The exchange rate also usually reacts to changes in the CNB’s rates, especially if such changes are sizeable and are perceived as long-term. The exchange rate in turn strongly affects prices of imported goods and hence inflation. With a longer lag it also affects exports and imports, aggregate demand and, again, inflation.
The model also takes on board – in a simplified, model way – the behaviour of the central bank itself which is consistent with its statutory objectives. The overall forecast therefore includes the projected path of interest rates. In its materials for the public, the CNB calls this projection the “interest rate trajectory consistent with the overall forecast”. The interest rate projection indicates the central-bank interest rate policy that is consistent with the economic outlook and the inflation target. However, it should not be understood as a binding commitment by the CNB as regards the current and future level of interest rates. It simply serves as a guide for real monetary policy decision-making. The arrival of new information since the forecast was drawn up and different views of the board members of economic developments than those outlined in the CNB forecast mean that the actual interest rate path may deviate from the forecasted path. The same applies to the forecast for the exchange rate of the koruna to the euro. The CNB is the only central bank in the world to publish a forecast for the nominal exchange rate vis-ŕ-vis a specific currency.
Why is the inflation target sometimes not hit?
Despite carefully considered monetary policy decisions, inflation can sometimes diverge from the target. This happens mainly when such decisions are based on predictions that fail to materialise. Economic forecasting is a very difficult business, and all macroeconomic forecasts – not just those drawn up by the CNB – can turn out to be wide of the mark to a greater or lesser extent.
The most frequent – although by no means only – cause of failures of macroeconomic forecasts is a sharp change in the value of some external variable of relevance to Czech inflation. Such variables, which include the exchange rate and world prices of raw materials and food, can be predicted only with a high degree of uncertainty. But they have regular and discernible impacts on Czech inflation, as evidenced by the nation’s rather troubled inflation history (see Figure 2). In past years, difficult-to-predict changes to administered prices, fees and indirect taxes have also played a major role in determining inflation.
Figure 2: Inflation in the Czech Republic (annual growth in consumer prices in %)
Imagine that an external shock has caused inflation to move outside the target band over the coming quarters. The CNB could, of course, respond by dramatically changing its monetary policy instruments to force inflation back on target. However, such a response could result in an undesirable destabilisation of the economy. Moreover, we need to consider whether the manifestations of the shock in the first few quarters – known as its first-round effects – are in fact essential changes in relative prices which ought not to be suppressed, i.e. the economic and price system is adjusting to the new situation by means of such changes, meaning that strictly speaking they are not changes in inflation at all.
If such first-round effects are very strong, the official inflation rate can depart from the inflation target band. For these reasons the CNB – like other inflation-targeting central banks – repeatedly tells the public in its publications that there may be situations where it is economically right to accept temporary non-fulfilment of the inflation target. The CNB’s monetary policy is focused on suppressing the second-round effects of the shock, which can emerge later as unwanted and genuinely inflationary ”echoes” of the first-round effects.
The inflation forecast takes several weeks to draw up
The key source material for the CNB Bank Board’s decisions is the CNB’s macroeconomic forecast. This forecast is drawn up by the Monetary and Statistics Department in interaction with the board members. It represents the CNB experts’ views of the most likely future evolution of the economy, including the behaviour of the central bank itself. The forecast is based on a consistent medium-term framework taking the form of a model approach which is supplemented with an expert opinion primarily affecting the short-term forecast horizon. The most relevant for monetary policy decision-making is the inflation forecast at the so-called monetary policy horizon (about 12-18 months ahead), which affects the current interest rate settings. The forecast is prepared by a large team of specialists working in the CNB’s prediction team. The process of compiling the forecast takes about one month, taking the form of a series of meetings of the prediction team. The initial meetings deal with the starting conditions of the forecast, in particular the position of the domestic economy in the business cycle. The settings of the starting conditions largely determine the message of the forecast. For this reason, the Bank Board is also involved in this discussion by means of a “meeting on the starting conditions”.
Expected external economic developments are another important assumption of the CNB forecast. To estimate the future evolution of the external environment (prices of energy-producing materials, producer price indices abroad, the business cycles of the Czech Republic’s major trading partners and the euro-dollar exchange rate), the CNB draws on the publication Consensus Forecasts, which brings together the Forecasts of a whole range of foreign analytical teams, and market outlooks.
Alongside the estimate of the starting conditions, the initial meetings of the prediction team also deal with the so-called short-term forecast, which is drawn up using single-equation and more sophisticated models and expert judgments and which describes economic developments in the coming few quarters. The short-term forecast for the next quarter is then entered into the core medium-term prediction model, which is made up of dozens of equations. The equations describe the key relationships within the Czech economy and between the Czech economy and the rest of the world. One of the core equations models the response of short-term interest rates to changes in inflation. This central bank response gradually returns inflation to the CNB’s target in the medium term. The forecast generated by the core prediction model is again subject to expert debate in the prediction team and to other potential expert adjustments. This process of integration of the expert and model views of future economic developments is the most demanding and time-consuming part of the forecasting process. At the end of this process we obtain the final version of the baseline scenario of the CNB’s macroeconomic forecast.
The forecast may therefore be viewed as the outcome of model and expert procedures, detailed considerations of short-term shocks, and comprehensive considerations of medium-term and long-term trends. Along with the preparation of the most likely economic scenarios, however, the main uncertainties and risks associated with the baseline scenario of the forecast (e.g. regarding external developments, the evolution of public budgets, uncertainties regarding the future development of key variables, etc.) are also discussed. On the basis of this discussion, specific alternative scenarios for the macroeconomic forecast can then be formulated at a second meeting with the Bank Board – a “meeting on alternative scenarios”. The baseline scenario and any alternative scenarios are then described in the Inflation Report, which is published eight days after the forecast has been discussed at the relevant monetary policy meeting of the Bank Board. Roughly the same description of the forecast – supplemented with technical passages that are of little interest to external readers – is then given in the Situation Report, which is an internal document intended for the Bank Board’s decision-making and which is published six years later.
The Bank Board makes decisions on the basis of Situation Reports
The situation in the Czech economy does not usually change fast enough to warrant this very time-consuming forecasting process each and every month. The forecast is thus prepared by the Monetary and Statistics Department once a quarter, so that important statistical data published quarterly can also be incorporated. The forecast is submitted to the supreme governing body of the CNB, the seven-member Bank Board, in an internal document entitled the Situation Report on Economic and Monetary Developments as a key material for its monetary policy decision making at the beginning of February, May, August and November. In the event of extraordinarily dramatic developments in the economy, however, a new fast-track forecast can also be put together in the interim.
The Bank Board, however, holds a meeting regularly eight times a year; besides already mentioned months also at the end of March, June, September and December. In these months, the Situation Report does not contain a new forecast but brings comparison of the latest key macroeconomic figures with their forecast values, evaluates the situation with respect to the possible future course of inflation, and updates the uncertainties and risks attaching to the most recent forecast.
The meeting of the Bank Board usually begins at 9 a.m. with a discussion of the Situation Report, which is always presented to the Bank Board by the Monetary and Statistics Department several days in advance. The board members are also provided with an opinion on the Situation Report under discussion, drawn up by one of their advisers, and a Monetary Policy recommendation. This document contains arguments for the setting of higher/lower interest rates compared to the message of the baseline scenario of the current forecast and a recommendation by the Monetary and Statistics Department regarding the optimum monetary policy action and the communication thereof.
The discussion of the Situation Report at the Bank Board meeting opens with presentations by the Monetary and Statistics Department summing up the main ideas and the message of the forecast, the Situation Report and the Monetary Policy Recommendation. The presentations end with the formulation of the Monetary and Statistics Department’s own recommendation for the Bank Board in the area of the immediate interest rate settings and communication. Once the presentations are over, the members of the Bank Board are free to ask questions. In the final phase of the meeting, the Board goes into closed session to discuss the risks and uncertainties of the current forecast and the overall monetary policy context and to subsequently vote on the monetary policy action. This vote is not necessarily always unanimous and the final decision can differ from the message of the current forecast and from the Monetary and Statistics Department’s monetary policy recommendation.
The measures adopted are immediately disclosed in a press release and explained and expanded upon at an afternoon news conference, at which the ratio of the votes cast is also released. The press conference is made available to general public through audio and video recordings posted on the CNB website. A more detailed account of the discussion leading up to the Bank Board’s decision is published eight days later in the minutes of the meeting. This account in the end presents votes of the Bank Board members by name on the change in interest rates. On occasion of release of the CNB´s new quarterly forecast (in February, May, August and November), a forecast of the future development of the key economic variables (overall inflation, monetary-policy relevant inflation, GDP, the CZK /EUR exchange rate and the path of interest rates consistent with the forecast) is also disclosed at the press conference held on the day the decision is made, and on the CNB website. The full minutes of the Board meeting, the Situation Report and the Monetary Policy Recommendation are published six years later.
The CNB employs market instruments in its monetary policymaking
To implement its monetary policy decisions the CNB makes use of “indirect”, non-administrative market instruments. In other words, he CNB makes monetary policy not by means of orders, prohibitions, limits and suchlike, but by offering banks business transactions and commercial terms formulated in such a way that those banks in turn offer their partners transactions under terms the CNB views as desirable at that particular moment. Through this basic mechanism, and via the channels described earlier (i.e. via client interest rates, the Exchange rate, etc.), the CNB’s monetary policy aims gradually spread through more and more markets and transactions into the entire economy.
The main CNB instrument is the two-week repo rate. Banks have the option of depositing their excess liquidity at the CNB for a two-week period on the basis of repurchase agreements (“repos”) at a rate not exceeding the two-week repo rate. By changing the repo rate, the CNB influences short-term interest rates on the interbank market. This signal then spreads to interest rates throughout the economy, to economic activity and ultimately to inflation.
In some situations the CNB may use other instruments at its disposal. For instance, it may conduct FX interventions to influence the koruna exchange rate and moderate excessive exchange rate volatility. The CNB used FX interventions from November 2013 until April 2017 as part of its exchange rate commitment with the aim of providing the required monetary policy easing in a situation where monetary-policy interest rates had reached “technical zero”.
The Czech Republic’s accession to the euro area
Upon the accession of the Czech Republic to the European Union and the Economic and Monetary Union, the CNB became part of the European System of Central Banks. However, until the euro is introduced and the CNB becomes part of the “Eurosystem”, the CNB will continue to conduct monetary policy autonomously.
The Czech Republic has the status of “Member State with a derogation” regarding the adoption of the euro, meaning that it will introduce the single currency later on. For EU member states, joining the euro area is conditional on fulfilling the “Maastricht convergence criteria”. This is a set of requirements defining areas in which the candidate countries must converge towards the euro area economies.
The CNB is convinced that the Czech Republic should not join the euro area before economic conditions allow for doing so. In particular, it is necessary to continue with the public budget consolidation process and with the structural reforms to increase labour market flexibility. At the same time, the euro area debt crisis and the methods being used to resolve it are not creating favourable conditions for euro adoption in the Czech Republic.