Exit from the exchange rate commitment
- Both the public and firms have benefited from the stable exchange rate; why doesn’t the CNB stick with it instead of returning to the now “obsolete” inflation-targeting regime?
- How will the exchange rate behave after the exit?
- What does it mean when the CNB says it stands ready to intervene against excessive exchange rate fluctuations?
- In what situation will the CNB intervene and in what situation will it leave the exchange rate without intervention after the exit?
- Can people at last look forward to cheaper holidays abroad?
- What will the CNB do with the euros it has bought?
- How will the interventions affect the CNB’s financial results?
- Is there a risk of negative interest rates being introduced at the time of the exit?
- When will the CNB increase interest rates above zero?
- Will the marked rise in interest rates assumed in the forecast actually occur?
- Why is the CNB’s forecast overshooting the inflation target?
- Will the CNB intervene against a weakening koruna?
- Is there a risk of a return to some form of exchange rate commitment in the future?
Independent monetary policy operating under inflation targeting benefits the Czech economy. This was demonstrated clearly after the global crisis broke out. The just ended exchange rate commitment was not a new CNB monetary policy objective but a temporary instrument used after the room for further interest rate cuts had been exhausted. Price stability – expressed as 2% inflation – remains the CNB’s statutory objective. A (managed) exchange rate float has long been consistent with inflation targeting. The exchange rate often acts a shock absorber in our small open economy. Adjustment through exchange rate movements is smoother and less painful than adjustment through real variables such as employment or wages.
In the long run, the exchange rate reflects economic fundamentals. However, the central bank can use its policy tools to dampen large exchange rate fluctuations that are not consistent with economic developments. We envisage the floating exchange rate regime being applied until the Czech Republic joins the euro area, i.e. until ERM II. Euro adoption is a political decision and cannot be expected in the foreseeable future. ERM II entry was therefore never considered as an option for exiting the exchange rate commitment.
The koruna exchange rate may move in either direction.
The market expects the koruna to appreciate. This expectation is supported by a modest positive interest rate differential relative to the euro area. The repercussions of the ECB’s quantitative easing programme will probably act in the same direction. A fundamental factor of the Czech koruna’s moderate nominal appreciation trend is renewal of its long-term real equilibrium appreciation. However, the pace of this equilibrium appreciation will be significantly lower than before the crisis, as the convergence and growth potential of the Czech economy is gradually decreasing over time.
On the other hand, there are also factors which will act against a strengthening of the koruna. These include the fact that the koruna was slightly overvalued before the commitment was adopted and that the initial weakening of the real exchange rate compared to the estimated equilibrium has in the meantime passed through to domestic prices, wages and other nominal variables. The fact that many exporters hedged themselves against exchange rate risk and that financial investors will be closing their koruna positions after the exit from the exchange rate commitment may at the same time lead to a situation of shortages of foreign currency in the market – the market is already heavily overbought in crowns. It thus cannot be ruled out that the koruna will depreciate beyond CZK 27/EUR after the exit and the rate may move in either direction for some time.
In any case, if the koruna is excessively volatile in both directions, the CNB will stand ready to dampen these swings by intervening.
The CNB has indeed made it clear for some time now that it is ready to suppress excessive fluctuations of the koruna-euro exchange rate following the exit. In the CNB’s view, excessive fluctuations mean exchange rate movements which could jeopardise price stability and, in turn, financial and overall macroeconomic stability in the Czech economy, and therefore also the fulfilment of the CNB’s statutory mandate. Exchange rate movements lasting hours or days, with swings in either direction being subsequently corrected by opposite movements, cannot be regarded as excessive fluctuations. The CNB will respond to strong and longer-running exchange rate movements at its discretion. However, this does not necessarily mean that the CNB will return to the market immediately in the first moments after the exit, as soon as the exchange rate starts moving. It is sensible to let market forces manifest themselves.
Whether or not the CNB will intervene will depend on the current assessment of market developments and their risks to the economy, and particularly to sustainable fulfilment of the inflation target. There is no definition of “excessive volatility” set in advance, as it depends on the specific conditions in the economy and on the financial market. The CNB will seek to prevent excessive appreciation of the koruna from posing a risk to sustainable fulfilment of the 2% inflation target and sound economic developments. Any interventions will be made following approval by the CNB Bank Board in line with the exchange rate regime of managed floating. One of the key characteristics of this regime is that the central bank does not announce any intervention limits in advance. In any case, this does not mean that we will make a panicky response to any short-term exchange rate movements.
We understand that this may be the most important exit-related question for the man or woman in the street. However, the exchange rate may move in either direction after the exit from the commitment, i.e. after the return to a floating exchange rate. From a longer-term perspective, the koruna is likely to revert to a gradual appreciation trend if the Czech economy continues to perform well. This would indeed make holidays cheaper. However, the average citizen spends only a very small proportion of his or her income abroad.
People should therefore take pleasure mainly from the fact that the Czech economy is thriving and has no visible imbalances. The exit from the exchange rate commitment can be viewed as a symbolic close to an era that started with a global financial and economic crisis and continued with a long and relatively deep recession which threatened to turn into harmful deflation. Since then, however, the Czech economy has been growing again for a number of years and it is now operating at its full production potential. Unemployment is at lower levels. A sustainable and robust return of inflation to the CNB’s target is a sign that we are achieving price stability. In line with this, our monetary policy can return to normal operation.
The CNB will keep the euros it has bought in its international reserves and will continue to invest them in high-quality, safe instruments. It will not sell the returns on those reserves for the foreseeable future.
Under Article 98 of the Constitution of the Czech Republic, and in accordance with primary EU law, the primary objective of the Czech National Bank is to maintain price stability. The exchange rate depreciation in 2013–2014 helped to generate a book profit for the CNB, thanks to which the CNB's accumulated book loss has been repaid in full. This, however, was not the purpose of the interventions, as the primary objective of monetary policy, i.e. to maintain price stability, always has priority over the impacts of the CNB's measures on its financial results. In the long run, the CNB's financial results will depend on exchange rate and interest rate developments in the Czech Republic and abroad. The long-run appreciation trend may be renewed after the exit from the regime of using the exchange rate, but at a much lower level than before the crisis.
The CNB is not ruling out the use of negative interest rates for a limited period of time to ward off speculative capital. However, this is not a preferred instrument and the CNB would only use it in an exceptional situation. From an economic point of view, the exit is a step towards less easy monetary conditions and should be followed some time later by a gradual increase in interest rates. The introduction of negative rates would be a step in the opposite direction.
The CNB will most probably raise interest rates some time after the exchange rate commitment is discontinued. After the CNB exits from the exchange rate commitment, it will determine – on the basis of analyses and observed developments – how great and urgent is the need to tighten monetary policy further by increasing interest rates. This cautious approach is driven by efforts to first help stabilise the exchange rate after the exit and only then start using the standard monetary policy instrument, namely interest rates, again.
The fact that the forecast contains a post-exit increase in 3M PRIBOR market rates is mainly confirmation that the time is right for the exit and the CNB’s monetary policy can start to move fairly quickly to a less accommodative stance. However, the CNB has long been communicating that monetary policy rates will in reality be increased some time after the exit, once the CNB is satisfied that the post-exit exchange rate developments have delivered part of the desired tightening of monetary conditions. Monetary policy rates will thus probably be raised at one of the Bank Board’s post-exit monetary policy meetings.
For the interest rate path in the CNB forecast, its generally holds true that the arrival of new information between two forecasts or an asymmetric assessment of the balance of risks to the current forecast by the Bank Board may cause the actual interest rate path to deviate from the forecast.
The expected temporary overshooting of the inflation target – probably to the upper boundary of the tolerance band around the target – is an expression of the fact that the CNB, in line with its previous communications, exited the exchange rate commitment only when there was a clear prospect of sustainable and robust fulfilment of the inflation target. In this situation, the CNB’s monetary policy can head towards a less accommodative stance. The first step in this process is the exit from the exchange rate commitment. This will show up in inflation with the usual time lag. After a time, inflation will stabilise close to the 2% target. In the meantime it will be slightly above the target, but at the monetary policy horizon, i.e. in 12–18 months’ time, it will return to 2%.
After more than four years of undershooting, a short-term overshooting of the inflation target cannot be viewed as a problem. Moreover, inflation is being affected by a number of one-off shocks which will largely fade away over a time scale of one year. In addition, the room for tightening monetary policy by raising interest rates has no upper bound. The CNB views its target symmetrically and will therefore be ready to raise rates in order to keep inflation close to the target if inflationary shocks hit the economy.
Will the CNB intervene against a weakening koruna?
If necessary, we can respond to such developments by raising interest rates, so this is a more comfortable option for us. However, if the weakening of the koruna is really pronounced, interventions in the foreign exchange market cannot be ruled out beforehand.
Any strong or sustained anti-inflationary shocks might renew the risk of a sizeable and long-running undershooting of the inflation target or even the threat of deflation in the future. After the room for easing monetary policy by cutting interest rates has been exhausted, this might force the CNB to use the exchange rate as a monetary policy instrument again or to apply another unconventional instrument. However, a return to the exchange rate commitment is highly unlikely in the near future, as inflation is above the CNB’s 2% target in an environment of solid growth of the Czech economy, rising wages and related robust domestic and overall inflation pressures.