CNB Monetary Strategy document
The Czech National Bank (CNB) is presenting this document to the Government of the Czech Republic as a basis for co-ordinating monetary policy with the economic policy of the Government. In the interests of creating as favourable economic and political conditions as possible for the dynamic development and macroeconomic stability of the Czech economy, the CNB is proposing that a common target of achieving price and monetary stability be adopted.
Overcoming the economic decline, ensuring long-term prosperity and narrowing the gap in the performance of the Czech economy in relation to the EU are key preconditions for the further development stage. This concerns not only economic revival, but above all the creation of conditions for sustainable long-term growth. The experience of the world economy clearly documents that dynamic growth and price stability are not mutually exclusive or antagonistic, but, on the contrary, that they are mutually implicit and conditional. Growth under concurrently widening internal disequilibrium and accelerating inflation or under external disequilibrium can be of only a temporary and short-term nature. As previous developments in the Czech economy have shown, sooner or later there is a correction accompanied by exchange rate movements and inflationary pressures with negative effects on longer-term growth potential. Countries with a stable currency and a balanced macroeconomic situation are not forced into these repeated corrections of disequilibria through restrictive policy and therefore achieve a higher rate of development in the longer term. There is also a feedback effect: stable economic growth creates favourable conditions for maintaining price and monetary stability in the long run.
Sharing and implementing an economic strategy which optimally combines and balances both dimensions of the above-mentioned mutual relationship is therefore in the common interest of the Government and the CNB, as well as of all other institutions and market participants. The central bank derives its role in this strategy from the provisions of Article 98 of the Constitution of the Czech Republic and Act No. 6/1993 Coll. on the Czech National Bank (Article 2), which charges the Bank with ensuring the stability of the currency. Currency stability has its internal and external elements: stability of domestic prices and the exchange rate. A monetary policy which attempts to achieve and then maintain price stability at minimal cost and without excessive fluctuations in economic output and employment is the central bank´s contribution to the creation of a pro-growth environment. The central bank thereby in fact supports the Government´s economic policy aimed at boosting growth and increasing employment.
In Chapter 2 of this document, the starting points and arguments relating to the achievement of price and monetary stability are identified. High inflation tends to be very unstable and volatile. Its costs are multiplied in the conditions of a small, open economy, and therefore it is desirable not only to maintain the results of the disinflationary process achieved so far, but also to converge gradually towards the standard in EU countries. On the other hand, the speed of the convergence and the time horizon for achieving it must take into consideration the depth of future adaptation processes. In particular, there needs to be sufficient room for relative prices to adjust.
In Chapter 3, the central bank´s proposal for a consensual setting of the target for achieving price and monetary stability is described in detail. This involves a long-term target situated within the horizon of the year 2005. We expect that it will be precisely in this period that the demanding stability criteria associated with EU accession will be relevant. The CNB believes that the proposed target will be supported by the Government and will become an integral part of overall economic strategy.
Chapter 4 of this document deals with the procedures for implementing the long-term target. In the Czech economy, as in an increasing number of advanced and developing countries, an institutional framework of inflation targeting has been applied. This framework has also been used by the European Central Bank. Inflation targeting is based on a multi-criteria approach to decision-making regarding the setting of monetary policy. It has the advantages of transparency, the use of a full set of indicators of future inflation development, and the effective influencing of the inflation expectations of market participants through the setting of targets progressing towards a low-inflation economy. It is these priorities of inflation targeting that create the preconditions for minimising the costs of achieving and maintaining price and monetary stability. It is the responsibility of the central bank to take appropriate steps so that the long-term target is met. The rule is that when choosing the trajectory and setting the successive medium-term targets, monetary policy must not give rise to an increase in inflation. It is desirable that this principle be shared also by overall economic policy (the only possible exception to this could be a decision on an accelerated scenario of regulated price correction).
The final, fifth chapter of this document justifies why the co-operative stance of not only the Government, but also Parliament, the trade unions and employers towards the implementation of the long-term strategy of price and monetary stability is desirable. This stability generates a favourable macroeconomic environment and is an important prerequisite for sustainable and dynamic economic growth. However, achieving and sustaining it could be associated with lower or higher costs. It is in the common interest of all those involved that these costs be minimised. This requires a co-operative approach, joint support for the achievement of price and monetary stability, and decision-making consistent with this stability. Chapter 5 formulates suggestions for intensifying the co-ordination between the Government and the central bank.
In view of the importance of achieving a consensus on the long-term strategy for price and monetary stability and of securing a co-operative approach by economic and political institutions, social partners and other market participants, the CNB is submitting this document to the wider public as well as to the Government. In the context of monetary policy transparency, the CNB considers this approach desirable.
2. Starting points for setting the targets of price and monetary stability
For the economic and political decision-making process, the concept of price and monetary stability must be identified and specified more clearly. The setting of an inflation target for an appropriate long-term horizon serves this purpose. The CNB derives this horizon from the following starting points:
(i) low inflation is one of key conditions for sustainable growth, and at the same time is highly valued by wide circles of Czech society,
(ii) the term "low inflation" must reflect the specific conditions of a small but, at the same time, very open Czech economy, moreover tightly interlinked with the EU by its geopolitical position and close economic ties,
(iii) the rate of progress towards price and monetary stability and the anticipated time horizon for achieving this must take into account necessary structural adaptations, particularly the adjustment of relative prices,
(iv) the long-term inflation target must be consistent with the strategy for our integration into European institutions, and above all with the demands of EU and EMU accession.
High inflation tends to be unstable and volatile, which substantially increases its costs. The experience of the world economy, as well as theoretical conclusions, confirm the negative impact of high and unstable inflation on economic growth. Inflation reduces real incomes and savings; higher inflation also implies higher nominal interest rates. Since higher inflation increases the uncertainty about future relative prices and about the price level, both domestic and foreign financial markets require a higher risk premium as compensation for the increased uncertainty. There occurs a fixing and inertia of inflation and depreciation expectations in the decision-making of economic entities. Because of the volatility of higher inflation, investors focus on short-term financial investments (speculative activities) and hedging against inflation instead of on longer-term investment projects in the real economy. Inflation creates tax distortions, uncontrollably reallocates incomes, and represents an implicit tax burden on savers, who are unable to maintain the purchasing power of their savings.
The Czech economy is a small, very open economy, both in terms of trade and finance, with liberalised capital flows. Besides that, it directly borders on the EU low-inflation area. In these conditions, sustained high inflation and the consequent interest rate differential represent a significant factor of instability. This shows up in exchange rate volatility, unstable development on financial markets and in high sensitivity - particularly of short-term capital flows - to the risk premium, with negative consequences for the stability of domestic economic development, prices and growth. In contrast to the major and relatively closed economies (on which assessments of the impacts of various levels of inflation have tended to concentrate), the conditions of the Czech economy place significantly heavier demands on reducing the inflation differential if its destabilising consequences are to be limited. Therefore, achieving price stability comparable with that in our main partner region, ie the EU, is essential for minimising the risks of the destabilisation tendencies ensuing from the conditions of a small and very open economy.
The correction of relative prices requires sufficient room and an appropriate time horizon. Changes in relative prices in a transition economy have two different causes. First, there is the correction of relative prices given by "inherited" deformations. These involve mostly - although not exclusively - the prices that have up to now been regulated. These corrections should be effected within a limited period. Second, there are standard and never-ending processes of relative price adjustment reflecting changes in the relations of productivity and costs and in the structure of domestic and foreign demand, as well as other factors. This adjustment, especially of the relative prices of tradable and non-tradable goods and services, will have to continue even after the initial deformations have been corrected.
Some relative prices in the tradable goods and services segment, as well as in administratively regulated prices, have already been corrected. Nevertheless, analyses testify to the large amount of adjustment which remains to be carried out. Given the limited downward flexibility of prices it must be assumed that this adjustment will lead to relatively faster growth in the domestic price level. Therefore, the horizon and level of the long-term inflation target need to take into account the necessary adaptation of the price level ensuing from the adjustment of relative prices.
The arguments for price and monetary stability are valid regardless of integration into European structures. However, the long-term economic strategy, an integral part of which will be the price and monetary stability target, is to a large extent predetermined by the demands and the time horizon of EU and EMU accession. It is therefore necessary that its dimensions be harmonised with the demands of the proposed phases of our integration into European structures. It is also desirable to evaluate realistically the potential costs and effects of our integration into the individual phases of the European integration process and to negotiate their horizons and conditions accordingly.
EU accession in itself is not tied to any quantitatively specified criteria for price and monetary stability. Nevertheless, as early as in this phase it is desirable to create conditions for keeping inflation and the interest rate differential as low as possible. This already ensues from the necessity of creating preconditions for closer links of our currency with the euro, regardless of whether the rules for the current exchange rate system (ERM II) will apply to new EU member states, and thus to EMU candidates, or whether the scheme will be adjusted. It is also possible that there will not be a significant gap between the Czech Republic´s entry into the EU and into EMU.
Accession to the eurozone is tied to the fulfilment of a set of macroeconomic criteria, including price and monetary ones. The current member states qualified for membership by meeting the Maastricht convergence criteria. In the price area, the criteria require that inflation measured by the year-on-year consumer price index (CPI) not exceed the average of the three countries with the lowest inflation by more than 1.5 percentage points. At the same time, nominal long-term interest rates in candidate countries must not exceed the average value of the three countries with the lowest inflation by more than 2 percentage points. In addition, it is required that the exchange rate be included in the ERM exchange rate system for at least two years prior to EMU entry and fulfil its stability criteria.
Given the ongoing adjustment of relative prices and the certain distortion in expressing changes in the quality of goods and services, as well as in technological progress, the European Central Bank has defined price stability as inflation of less than 2%.
Differences in the price levels of the CR and the EU
Some Czech experts consider the substantial gap in price levels to be the principal problem of the country´s EU accession. This view has been fostered by the fact that, at present, the price level in the CR is only 43% of the EU average and international comparisons (eg with Poland and Hungary) indicate that the difference is bigger than would correspond to our economic level. From this it is concluded that if the gap is maintained, or even if it is narrowed somewhat, it will be a destabilising factor in our accession to the EU, or may even prevent it altogether. Under this line of reasoning, attempts to stabilise at low inflation are in fact undesirable or even counterproductive.
Regarding this issue, it is necessary to note the following:
- the current relatively low price level is to an overwhelming extent the result of relative prices in nontradable or nontraded goods and services,
- growth in the price level for these goods and services segments is conditioned by growth in real income and wage levels. However, by definition this growth requires corresponding growth in productivity at the national economy level,
- the relative price level in relation to foreign countries is mediated by the exchange rate. If growth in the domestic price level were to lead to a corresponding depreciation of the exchange rate, price levels would not converge,
- to narrow the difference between Czech and foreign price levels, any faster increase in the domestic price level (the inflation differential) therefore needs to be more than matched by increased productivity growth. This creates the prerequisites for stability of the exchange rate level, or even for a nominal appreciation.
From these arguments it follows that the problem of price levels is a derived one. Relative productivity growth is the determining and primary factor for narrowing the gap in price levels. This is generated by processes at the microeconomic and institutional level. Macroeconomic policy cannot set itself the goal of achieving price level convergence. The important thing is to create an environment and introduce mechanisms that will lead to an acceleration of productivity growth; this is exactly what the strategy of price and monetary stability is aimed at and contributes to.
It is true that major differences in price levels coupled with the sudden implementation of EU standards in the Czech Republic´s accession period, particularly in the social, wage, tax, environmental and agricultural policy areas, pose the risk of a potential shock and discontinuity. However, the EU can be expected to have modified some standards, eg in agricultural policy, by the time the country enters the EU. Furthermore, it is necessary to assume that still in the pre-accession phase, there will be a more significant convergence towards the above-mentioned standards, thus mitigating the possible intensity of sudden changes.
The convergence processes in the price area will necessarily continue also after the Czech Republic´s accession to the EU. These are long-term processes, with inertia and many barriers. After all, this is exactly what the experience of the EU countries documents. Even after decades of a single market and integration processes, the price levels of the member states continue to differ by up to ą30% from the EU average.
3. Consensual setting of the long-term inflation target
To achieve a balance between economic growth and price and monetary stability, it is desirable that the main parameters of the long-term inflation target be the result of a joint assessment and consensus between the Government and the central bank.
The CNB proposes that the long-term inflation target for year-on-year net inflation be specified in the form: 2% ą 1 percentage point; this target should be achieved in 2005.
This proposal is based on:
- the arguments given in the above starting points,
- the assumption that the Czech Republic´s accession to the EU can be expected sometime between 2003 and 2005.
The proposed mid-value for the long-term inflation target, and consequently the definition of the price stability category for the Czech economy, is slightly higher than the target declared for eurozone countries by the European Central Bank. This primarily reflects the fact that the probable extent of the distortion of price indices due to changes in the quality and range of goods and services, as well as to the more intense adjustment of relative prices in the still transforming Czech economy, will continue to be larger than in eurozone countries.
The ongoing transformation, particularly the non-linear distribution of the effects of the fundamental correction of regulated prices and adjustment of indirect taxes (for which a medium-term programme has not yet been specified), requires that the long-term inflation target be specified in the form of net inflation. The CNB expects that by the year 2005 the effects of the correction of regulated prices will be absorbed and that net inflation indices will in principle develop in parallel with consumer price indices. To achieve comparability over time and to be able to derive monetary policy targets directly from the consensual long-term target of the Government and the central bank, it is necessary to specify this target in the form of net inflation. Targeting inflation in the form of the CPI is conditioned by the existence of a binding long-term scenario for price deregulation and changes in indirect taxes.
A comparison of the proposed long-term target for 2005 (2% ą 1 percentage point) and the current medium-term target for the year 2000 (4.5% ą 1 percentage point) shows that the long-term target establishes only a very slow trajectory toward price and monetary stability. A linear trajectory (from which the reality will deviate to a greater or lesser extent in individual phases) would mean net inflation falling by about 0.5 percentage points a year. In essence, this involves creating the prerequisites for stabilising the disinflation that has already been achieved and for completing the shift to a low-inflation economy.
In locating the realistic alternatives for the Czech Republic´s accession to the EU in the period between 2003 and 2005, the CNB regards it as justified to consider the 2005 horizon as the period for attaining price and monetary stability. A comparison of the potential costs and effects for the possible alternatives, ie for 2003 in particular, confirms the legitimacy of this choice.
4. Inflation targets and monetary policy strategy
The consensus between the Government and the central bank relates to a long-term objective as the ultimate point on the path towards price and monetary stability. The CNB will derive its monetary strategy and inflation targets from this objective. To support co-operation between economic and political institutions, targets will be declared in the following way: the target for the end of the relevant year will always be set at the end of April of the previous year.
This procedure allows work on preparing the macroeconomic framework for the state budget draft for the following year to take into account the inflation target and enables trade unions and other market participants to use this target in formulating their wage and pricing strategies.
During the second half of 1998 and at the beginning of 1999, inflation expressed by both the CPI and net inflation slowed sharply because of both exogenous and internal factors. However, this trend was not specific to the Czech economy; a major fall in commodity prices on global markets fed through into the price indices of most countries. The weight of this positive price shock and other exogenous factors on the net inflation index in 1998 is estimated at 2-3 percentage points. This trend was also fuelled by a substantial contraction of individual segments of domestic aggregate demand owing to restrictive fiscal, monetary and wage-income policies.
For this reason, the low inflation outturns recorded at the end of 1998 and the beginning of 1999 alone do not mean that the characteristics of a low-inflation economy have already pushed through. The fall in the consumer price and net inflation indices have not yet been adequately reflected in inflationary expectations or in the decision-making of economic entities. This is illustrated, among other things, by the results of wage bargaining for 1999. The Czech economy is still struggling with serious structural defects, a lack of flexibility and high transaction costs; solving these problems is the main prerequisite for a low-inflation economy. It is therefore impossible to expect that the existing low inflation level can be maintained and convergence to EU standards achieved without further economic and political effort.
In forthcoming years, the CNB will announce its inflation targets based on an assessment of new information and forecasts to ensure that the long-term inflation target is met within the projected horizon and at minimal cost. When setting the upper and lower limits of the corridor for its targets, the CNB will be guided by the principle that the setting and implementing of these targets must not:
- generate an acceleration in inflation (allowing for exogenous and temporary influences),
- be directed below the price stability level, defined as 2% ą 1 percentage point.
The achieving of inflation targets is the main factor determining decision-making about changes in monetary policy instruments at any specific stage. At the same time, it should be taken into account that in reality a whole range of shocks and extraordinary events can occur whose causes are fully or largely outside the reach of monetary policy measures. (Positive and negative shocks on the supply side pose particular problems.) It would be economically irrational and costly (in terms of deviations in output and employment) for monetary policy to try to correct or eliminate the consequences of such shocks on a short-term basis.
For this reason, a set of exceptions has been defined which justify deviations from the medium-term inflation target. These exogenous and unforeseen factors include:
- substantial deviations of global prices of raw materials, energy sources and other commodities from the prediction;
- major deviations of the exchange rate that are not connected with domestic economic fundamentals and domestic monetary policy;
- marked changes in the conditions for agricultural production with an impact on agricultural producer prices;
- natural disasters or similar extraordinary events with cost and demand impacts on prices.
However, once these shocks have unwound the CNB will formulate its monetary policy so as to keep inflation on track to meet the long-term target.
The public was informed of the above exceptions at the end of 1998 when the short-term inflation target for 1999 was declared. In future, these exceptions will also include one-time, difficult-to-predict price shocks associated with the adoption of EU norms.
The CNB will declare the inflation target for 2001 after reaching consensus with the Government regarding the long-term inflation target and after informing the public about this. Future targets will be declared in subsequent years. The main determinants for these targets are:
- the long-term target (assumed consensus: 2% ą 1 percentage point), implying a disinflationary trajectory,
- the existing targets for 1999 (4.5% ą 0.5 percentage points) and 2000 (4.5% ą 1 percentage point),
- the macroeconomic and monetary outlook for the period in question.
5. The necessity of a co-operative approach to attain price and monetary stability
Achieving and maintaining price and monetary stability is one of the preconditions for long-term development for the small and very open Czech economy. It is also an inevitable prerequisite for future integration into the EU and EMU. It is in the common interest of the Government, central bank and all other entities, including trade unions, to achieve this goal at minimal cost.
Agreement on the long-term objective of price and monetary stability and a joint commitment from the Government and the central bank to meet it will make it possible to minimise the costs. Consensus increases the credibility of inflation targets and has favourable effects on inflationary expectations, thereby reducing the costs of anti-inflationary policies. It makes it easier for the Government to formulate its medium-term plans for fiscal policy and budget performance. Consensus also helps employers and trade unions reduce uncertainties during wage bargaining and allows them to extend the time horizon for this process. This reduces the risk of wage bargaining being based on expectations which are not consistent with inflationary developments and which will eventually lead to growing unemployment and diminishing competitiveness abroad. For investors it creates a more stable base for their projections and decisions. It also has significance as a positive signal for the process of EU accession and for the credibility of the Czech Republic´s progress in fulfilling its obligations in this respect.
Analyses clearly show that with a co-operative approach and credible inflation targets shared by economic entities, it is possible to achieve the objective of price and monetary stability within the proposed horizon of 2005. Moreover, the positive development of inflationary expectations, reduction of transaction costs and better flexibility and adaptability of the economy can minimise the costs accompanying the above process. In contrast, with non-cooperative decision-making and behaviour it is necessary to rely more on restrictive economic policies. Under such conditions, the costs, in the form of negative effects on aggregate economic output and employment, could be much higher, or the time horizon for meeting the long-term target might have to be prolonged.
(i) The importance of the credibility of and joint support for the inflation targets
The expectations of economic entities are fundamental for shaping price developments and for progress towards price stability. If these expectations are consistent with the inflation targets, and if businesses, households and the Government and trade unions take the above targets into consideration in their decision-making, the conditions are created for the achievement and stabilisation of low inflation at minimal cost. Several examples from the past document the consequences of inconsistency in inflationary expectations built into wage bargaining or the budget. The result has not only been erroneous estimates of budget results and unfavourable effects on employment, but also higher disinflation costs.
(ii) Exchange and flows of information
The flexible exchange of information between the Government and the central bank and the provision of as much information as possible to the other players in economic development are the main prerequisites for a co-operative approach and effective co-ordination of economic policies.
The CNB has made a good progress in providing information to the Government, Parliament and the wider public. This includes in particular drawing up a medium-term outlook and regular quarterly inflation reports. The latter also contain the minutes of CNB Board meetings, which give an assessment of the current monetary situation and a justification of the monetary policy measures adopted. The minutes are also available to the public on the Internet. In addition, the Government, Parliament and wider public have at their disposal annual reports on monetary and economic development as well as regular half-year analyses and evaluations of the balance of payments. Senior CNB officers meet at working sessions with members of the parliamentary budget committee. Meetings with trade union representatives are also held on a regular basis. Moreover, the CNB is developing the practice of regular meetings with domestic and foreign analysts and journalists and is ready to further improve the flow of information for the interested public.
The CNB would welcome more detailed information about the medium-term programmes and intentions of the Government and other institutions. In this context, the most important areas for the central bank are those regarding the economic strategy and policy of the Government that directly affect the formulating of monetary strategy and policy. These include, among others, the medium-term outlook for the correction of regulated prices and tax changes, as well as the medium-term plans for fiscal policy.
The concept of net inflation, on which the CNB builds its inflation targets and monetary policy, to a certain extent "filters out" the primary consequences of corrections to regulated prices, and monetary policy need not necessarily react to these deregulatory shocks with a rise in interest rates. Nevertheless, the medium-term scenario for deregulation is an important piece of information, especially for estimating the inflationary stimuli ensuing from changes in the expectations of economic entities.
(iii) The desirable "mix" of Government economic policy and central bank monetary policy.
The economic policy of the Government, especially in the fiscal and wage-income areas, and the monetary policy of the central bank are communicating vessels and create the overall macroeconomic environment in the economy. Even though specific conditions change over time and in individual phases, as does the appropriateness of the settings of the above policies, the general trend should not be one of a tight monetary policy subsequently offsetting or counterbalancing excessively relaxed wage-income or fiscal dimensions. On the contrary, the conditions of the still transforming and, at the same time, very open Czech economy should normally require a prudent wage-income policy combined, as far as possible, with a more relaxed monetary policy.
(iv) Support for and anchoring of a low-inflation economy in relation to the external environment
In the present environment of increasing globalisation of capital flows, the vulnerability of small, open economies which are not sufficiently shielded by co-operation with the dominant institutions and monetary authorities in their regions is increasing. The Czech economy has a substantial degree of openness, and its economic and price development is sensitive to trends and changes in its external environment. It is therefore desirable to co-operate with international institutions, reduce in-built uncertainties and eliminate the unfavourable consequences of any deviations and the possibility of these being reflected in the decisions of foreign investors and domestic market participants.