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?
- Why did the CNB choose to weaken the koruna to CZK 27 to the euro to further ease monetary policy?
- What was the aim of using the exchange rate as a monetary policy instrument?
- What would have happened had the CNB not taken this decision?
- What were the economic effects and benefits of the exchange rate commitment?
- Key economic indicators – one year on
- Why did the CNB discontinue the exchange rate commitment in April 2017, and how does it conduct monetary policy now?
- Is there a risk of a return to some form of exchange rate commitment in the future?
- What will the CNB do with the euros it bought during the exchange rate commitment?
- How will the rise in international reserves due to the exchange rate commitment affect the CNB’s financial results?
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.
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.
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.
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.
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.
|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|
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.
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.
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.
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.