Assessment of the economic situation one year after the exchange rate commitment was adapted

The Czech economy went through a lengthy economic contraction in 2012–2013 owing to weak external and in particular domestic demand reflecting consolidation of public budgets and low household and business confidence. This supported anti-inflationary tendencies, and there was an increasingly real danger of the Czech economy slipping into deflation at the start of 2014. Its consequences would have been highly unfavourable and difficult to deal with, particularly if deflation had become incorporated into the expectations of economic agents. At the same time, monetary policy rates could not be lowered any further, as they had hit the zero lower bound in autumn 2012.

In November 2013, the CNB therefore – in line with its previous communication – started to use the exchange rate of the koruna as an additional instrument for easing monetary policy. Specifically, it announced a one-sided exchange rate commitment at CZK 27 to the euro and expressed its readiness to prevent excessive appreciation of the koruna below this level by intervening in the foreign exchange market. On the weaker side of this level, the CNB is allowing the koruna exchange rate to float. Following the announcement of the exchange rate commitment the koruna quickly depreciated beyond CZK 27 to the euro (thanks in part to foreign exchange interventions by the CNB) and soon stabilised without further interventions close to CZK 27.5 to the euro (see Chart 1) as the exchange rate commitment quickly established a strong degree of credibility.

Chart 1 (BOX) CZK/EUR exchange rate
Following the announcement of the exchange rate commitment the koruna quickly depreciated beyond CZK 27 to the euro and then stabilised slightly above it
(CZK/EUR)
 

One year on, it is appropriate to assess the effect of the CNB’s exchange rate commitment on the Czech economy. Table 1 shows that the Czech Republic’s key macroeconomic indicators are much better off than they were before November 2013. The economy is growing noticeably, and this is having a favourable effect on the labour market and household and business confidence. Headline inflation has fallen slightly compared to last year and deviated even further from the CNB’s 2% target, but – adjusted for the effect of tax changes – it has rebounded from the edge of deflation. Key economic data thus suggest that the weakening of the exchange rate has served its purpose. To assess its effect properly, however, we also have to consider other factors.

Table 1 (BOX) Comparison of key indicators
Key macroeconomic indicators are developing much more favourably than they were before November 2013; headline inflation is slightly lower
(annual percentage changes unless otherwise indicated)

(annual percentage changes unless otherwise indicated)

The marked change in the evolution of the Czech economy has been supported by a recovery in growth in the effective euro area. This recovery remains fragile, however, and economic growth in the Czech Republic’s major trading partner countries has increased subtly this year (see Chart 2). From the whole-year perspective, the current forecasts expect it to rise by only 0.5 percentage point. Another factor supporting the economic turnaround is a shift of domestic fiscal policy from a strongly restrictive effect of about -1 percentage point in 2013 to a slightly positive stimulus of approximately 0.3 percentage point this year. The above factors together explain almost 2 percentage points of the dynamics of the Czech economy this year. The dynamics, however, is another 1.5 percentage points higher, thanks to which the Czech Republic has started to outpace the effective euro area for the first time in a long time (see Chart 2).¹ This can be attributed to the easing of the monetary conditions via the weaker koruna, which has fostered a marked lead of Czech export growth over external demand growth and a recovery in domestic investment and consumption. The effect of expectations has played a strong role, as firms and households have stopped deferring their expenditure.

Chart 2 (BOX) GDP in the ČR and effective euro area
The domestic economy has recovered visibly more than the effective euro area
(annual percentage changes; seasonally adjusted)
 

From the point of view of inflation, the assessment of the impacts of the weakening of the koruna is more complicated at first sight, as inflation is still very low and its outlook has shifted substantially downwards since November 2013. The alternative scenario of the November 2013 forecast had expected inflation to return to the target at the end of this year and rise temporarily to the upper boundary of the tolerance band around the target at the start of 2015, whereas the November 2014 forecast expects it to stay in the lower half of the tolerance band for the whole of next year (see Chart 3). This is despite the fact that the duration of the exchange rate commitment has been extended from the originally planned start of 2015 to 2016 and the fact that the koruna is at a weaker level than the exchange rate commitment.

Chart 3 (BOX) Comparison of inflation forecasts
The inflation forecasts have fallen noticeably since the November 2013 alternative scenario was drawn up
(annual percentage changes)
  

It should be taken into account, however, that the deflationary tendencies in the euro area have deepened further in the meantime. This is reflected in a decline in both observed and expected foreign producer price inflation (see Chart 4). In addition, the decline in domestic administered prices is also deeper than expected last November. An analysis using the g3 core prediction model reveals that in normal circumstances the anti-inflationary effect of the above factors would have been reduced by interest rate cuts and by a fundamentally justified weakening of the nominal exchange rate of the koruna to maintain the price competitiveness of domestic production. However, given the zero lower bound on interest rates and the risks of exchange rate appreciation identified in November 2013, the decline in domestic inflation and the negative impact of external developments on domestic GDP and the labour market would have been significant had this monetary policy easing not occurred.

Chart 4 (BOX) Shift in the outlook for effective PPI
The outlook for industrial producer prices in the euro area has shifted significantly downwards since last November
(annual percentage changes; seasonally adjusted)
  

To sum up, the weakening of the koruna averted the threat of long-term deflation, which – in the light of new data – was much greater than suggested by the analyses a year ago. The weaker exchange rate of the koruna has passed through to import prices, adjusted inflation excluding fuels has turned positive for the first time in many years, and the anti-inflationary effect of the domestic economy has faded away as GDP growth has accelerated and the labour market has changed for the better.

¹ In November, the CNB had expected the weakening of the koruna to boost economic growth by about one percentage point in 2014 relative to the passive monetary policy scenario.