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CNB > FAQ > What was the exchange rate commitment?

What was the exchange rate commitment?

When did the CNB start using foreign exchange interventions, and why did it decide to achieve its monetary policy objective using the exchange rate?

The CNB Bank Board decided to use the exchange rate as a monetary policy instrument, and therefore to commence foreign exchange interventions, on 7 November 2013. For the Czech Republic, as a small open economy with a long-term excess of liquidity in its banking sector, this is a more effective instrument for easing the monetary conditions than any other. The decision to use the koruna exchange rate as a potential additional tool for monetary policy easing after the lower bound on interest rates was reached was made by the Bank Board in autumn 2012.

Why did the CNB choose to weaken the koruna to CZK 27 to the euro to further ease monetary policy?

In 2012–2013, the Czech economy went through a recession, reflected in rising unemployment, falling household income and consumption, and decreasing corporate profits and investment. The CNB reacted by using its main monetary policy instruments to the full, lowering interest rates to technical zero (0.05%) in late 2012. In addition, it pledged to maintain this record-low interest rate level for as long as necessary. In line with its statutory mandate, the CNB’s goal was and is to maintain price stability, thereby contributing to the stable development of the Czech economy. The CNB therefore started to communicate in autumn 2012 that it was ready to use other instruments should a further monetary policy easing become necessary. The exchange rate was chosen for this purpose for a number of good reasons. The very declaration by the CNB that it was ready to use the exchange rate led the koruna to weaken in late 2012 and early 2013. This slowed the disinflationary tendencies and helped the economy to take breath.

It became clear that the recession and the labour market downturn were fading only very slowly and their anti-inflationary effects, coupled with falling prices of commodities and energy, were leading to a further decrease in inflation. The CNB was expecting inflation to fall to zero in early 2014 and the price level adjusted for changes in excise duty on cigarettes to actually go down. Prices of many consumer basket items (consumer goods in particular) had long been declining. The CNB therefore acted to fulfil its statutory mandate to maintain price stability.

What was the aim of using the exchange rate as a monetary policy instrument?

The aim of using the exchange rate as an additional monetary policy instrument – and therefore of using foreign exchange interventions to weaken the koruna – was the same as in the case of interest rates. In line with the CNB’s statutory mandate, the objective was to maintain price stability in the Czech economy, which is expressed by the CNB’s inflation target of 2%. In other words, the aim was to prevent deflation, to ensure that the 2% inflation target was achieved in a sustainable manner and to accelerate the return to a situation where the CNB would again be able to use its standard tool, i.e. interest rates. The use of foreign exchange interventions as an appropriate tool for countering deflation risks had been recommended by an IMF mission in 2013. In terms of the CNB’s secondary objective, i.e. supporting the general economic policies of the government leading to sustainable economic growth, our action helped overcome the longest recession in the history of the independent Czech Republic, a continuation of which was not in the interests of most companies or the public.

What would have happened had the CNB not taken this decision?

The decision to further ease monetary policy was based on the CNB’s economic analyses. The CNB has a high reputation around the world, and especially among other central banks and international institutions (such as the IMF and the OECD), in the area of economic modelling, forecasting and monetary policy in general. Its analyses were showing that if monetary policy remained inactive, the Czech economy could fall into deflation lasting at least two or three quarters in 2014. That, however, was a very optimistic assumption, as historical experience shows that deflation can be very difficult to stop once it gets going. Prevention is therefore better than cure.

Without a further monetary policy easing by the CNB, there was a risk of the previous relative exchange rate stability ending and the koruna starting to appreciate markedly. The decline in the inflation expectations of firms, households and financial markets was meanwhile deepening. The CNB’s efforts to ease monetary conditions (i.e. to weaken the real exchange rate and reduce real interest rates) could thus have been negated without further action. Such an undesirable monetary policy tightening would have intensified the anti-inflationary tendencies in the economy, slowing or completely stopping the budding recovery and the improving labour market situation and driving the economy into another wave of recession or even into deflation, i.e. a sustained decline in the price level.

A decline in prices of goods and services may seem favourable from the consumer’s perspective, but it is extremely unfavourable and unwelcome at the national economy level. Central banks around the world try their utmost to prevent this from happening. This is because many firms and households postpone their purchases in expectation of falling prices. This, however, leads to a lack or deferral of demand. If demand is lacking, there is no need to produce as much. Firms lay off staff and household income and corporate profits decline, fostering a further decrease in prices. This is called a deflation-recession spiral, and when an economy gets into it, there is no easy way out. The very negative deflation experience of the 1930s remains etched in the memory of all economic policy authorities, especially central banks. Japan also has an adverse experience with deflation over the last two decades. In line with its mandate to maintain price stability, the CNB therefore decided to act to avert this risk, i.e. to ensure a faster return of inflation to the 2% target, safely away from deflation territory.

What were the economic effects and benefits of the exchange rate commitment?

The weakening of the exchange rate caused the threat of a deflation trap to disappear and economic growth to accelerate. In 2014, the Czech economy grew by 2%. Economic growth was supported by recovering external demand, by accommodative domestic monetary conditions due to the weakened exchange rate, and by higher government investment. The economy would have recovered much more slowly had monetary policy remained passive. If the CNB had taken no action, the growth in 2014 could have been as much as one percentage point lower.

The immediate effects of the weakening of the koruna may have been unfavourable for some, especially in the short term. Firms faced higher prices of commodities, materials and semi-finished products purchased from abroad, and households had to pay more for imported goods and energy. However, this unpleasant, and unfortunately necessary, negative side effect of the exchange rate weakening was only short-lived and positive effects gradually prevailed. As in medicine, sometimes a remedy with short-term negative side effects may be needed to restore a patient to health. The weakening of the koruna to CZK 27 to the euro caused prices of imported items to rise, supporting demand for domestic goods. It also demonstrated that waiting for prices to go down further wouldn’t pay, so many people started to save less and spend more. Czech firms thus gradually began to enjoy higher sales and hire more people and pay them better wages. Higher household income and consumption along with higher corporate profits and investment meant higher tax revenues for public budgets. The main benefit for the public was greater certainty as regards keeping or finding work. The important message to consumers was that there was no longer any point in deferring consumption in the hope that prices would continue to fall.

Key economic indicators – one year on

  Year-on-year change in %
As of 7 November 2013 As of 31 October 2014
Gross domestic product (s.a.) II/13 -1.3 II/14 2.5
Consumer Price Index 9/13 1.0 9/14 0.7
Monetary policy-relevant inflation  9/13 0.2 9/14 0.6
General unemployment rate (s.a.) 9/13 7.1 9/14 5.9
Average nominal wage in the business sector (in CZK, s.a.) II/13 25,199 II/14 25,542
Average nominal wage, total II/13 1.2 II/14 2.3
Number of job vacancies 9/13 39,040 9/14 56,600
Overall confidence indicator (index) 10/13 88.9 10/14 94.1

Why did the CNB discontinue the exchange rate commitment in April 2017, and how does it conduct monetary policy now?

The now discontinued exchange rate commitment was not a new CNB monetary policy objective, but rather 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. This means the CNB uses inflation targeting. The period after the onset of the global crisis showed clearly that the Czech economy benefits from independent monetary policy operating under this regime. 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.

Is there a risk of a return to some form of exchange rate commitment in the future?

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.

What will the CNB do with the euros it bought during the exchange rate commitment?

The CNB will keep the euros it 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.

How will the rise in international reserves due to the exchange rate commitment affect the CNB’s financial results?

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. Therefore, the CNB’s objective is not to maximise its profit. 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. Although the exchange rate returned to its appreciation tendency after the exit from the exchange rate commitment, in the long run the rate of appreciation will be much less pronounced than before the crisis.

The CNB weakened the koruna in the past. By contrast, it is now starting to apply the brakes by raising interest rates. Isn’t this a “brake-and-accelerate” policy?

By its very nature, monetary policy cannot accelerate economic growth and reduce unemployment in the long run. However, it can help curb fluctuations in growth and unemployment. In other words, it can smooth the business cycle. That is exactly what the CNB did in past years. It accelerated growth when the economy was at a low and unemployment was near an all-time high, thus preventing deflation from occurring. The monetary conditions, which until recently were very easy, are now moving towards a neutral stance in order to stop the economy and the labour market overheating too much. Such an overheating would cause inflation to remain above the target for an extended period of time and create other macroeconomic and financial imbalances. The desirable shift of the monetary conditions towards a neutral stance is taking place through appreciation of the koruna and an increase in interest rates. Economic growth enabled the CNB to end the exchange rate commitment and return to the use of interest rates as the standard monetary policy instrument. Raising interest rates is thus a return to normal. Despite that, interest rates are still well below the levels common in the past.

Shouldn’t the CNB have waited with the interest rate increase?

In a situation where the economy is above its potential, unemployment is below its natural rate and inflation is sustainably close to the target, there is a need to gradually move the monetary conditions to a neutral stance. Following the exit from the exchange rate commitment, a modest appreciation of the koruna against the euro initially fostered a desirable shift of the monetary conditions to normal. Keeping interest rates at zero could have caused an undesirable overheating of the economy, the credit market and the property market, leading to inflation significantly overshooting the target. The CNB therefore started to raise interest rates gradually in August 2017. Going forward, its key interest rate should gradually head towards the neutral level of around 3%. After all, the exit from the exchange rate commitment was conditional on the CNB returning before long to the use of interest rates as its standard instrument.

How come inflation overshot the CNB’s inflation target in 2017? According to your forecast, it looks like it will do so again in 2018.

The modest overshooting of the inflation target, with inflation moving in the upper half of the tolerance band around the target for the whole of 2017, was due to the fact that the CNB, in line with its previous communications, discontinued its exchange rate commitment only when sustainable and robust fulfilment of the 2% inflation target had been ensured. As in other advanced Western countries, hitting the 2% target equates to price stability. In this situation, the CNB’s monetary policy could start to head towards a less accommodative stance. The first step in this process was the exit from the exchange rate commitment. This was followed by the lifting of interest rates from their zero lower bound in August 2017. The CNB was the first central bank in the EU to raise interest rates. Inflation will remain above the 2% target this year, but it will return to the target in late 2018 or early 2019 due to the stabilising effect of monetary policy and the appreciating koruna. After several years of undershooting during the double recession in the Czech economy, a modest overshooting of the inflation target cannot be considered a problem. Inflation has additionally been affected by some one-off shocks. These include the introduction of electronic sales registration in the hotels and restaurants sector in late 2016, which increased inflation for almost the whole of 2017 but has been fading rapidly since the end of last 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.

The koruna has gradually been strengthening since the exit from the exchange rate commitment. How come prices of imported goods (such as electronics, tropical fruit and petrol) and holidays have not fallen, or have fallen much less than the appreciation of the koruna would imply? Were we looking forward in vain to a stronger currency and lower prices?

Import prices have been declining for several consecutive months and the decline is deepening gradually because of the strengthening exchange rate. There are several reasons why import prices and prices of imported goods in the consumer basket responded to the exchange rate appreciation by decreasing with a lag. Importers – like exporters – were able to hedge against exchange rate movements (not only using financial instruments, but also, for example, by incorporating exchange rate clauses into their contracts). As a result, exchange rate swings may not have been reflected proportionately in prices of imported goods, especially in the short term. It also took some time to sell off the stocks of goods imported while the exchange rate commitment was still in place. In general, it holds true that the decision to incorporate exchange rate movements into prices charged to domestic customers lies fully with importers and retailers, who include other cost and demand factors in their calculations in addition to purchase prices.

The increase in CNB interest rates has already been reflected in higher bank lending rates, but why aren’t deposit rates rising as well?

The interest rate increase has affected the whole financial market yield curve, which has begun to shift upwards and get steeper. Banks use this curve to derive the interest rates they charge their customers (firms and households) on deposit and loan products. The higher financial market interest rates are passing through more slowly to deposits than to loans because Czech banks have relatively ample deposits on their balance sheets for a number of historical reasons. Likewise, there is also enough overall liquidity in the Czech banking sector. As a result, banks are not forced to make deposits more attractive to savers as quickly by raising deposit rates. After a time, however, market conditions will prevail and deposit rates will increase. For example, higher returns offered to households and firms by collective investment institutions (such as money market funds and bond funds) may act in this direction. The returns on investment in such institutions will start to rise as, for example, Czech government bond yields increase. We can already see this happening. Banks will then counter any major outflow of money into collective investment funds by raising their deposit rates.