Escape clauses pertaining to the new inflation target
The Czech National Bank, by agreement with the Government, has announced an inflation target for annual consumer price index growth in 2002-2005. The inflation target takes the form of a continuous band descending evenly from 3%-5% in January 2002 to 2%-4% in December 2005. Following the shift from targeting net inflation to targeting headline inflation the CNB extended the range of cases in which exceptions from hitting the inflation target may be applied. These "escape clauses" now include changes in regulated prices whose impact on headline inflation would be greater than 1-1.5 percentage points, and step changes in indirect taxes 1 .
In the inflation targeting regime, the need for escape clauses derives from the relatively frequent occurrence of shock changes in exogenous factors (particularly demand-side shocks) that are completely or largely outside the purview of central bank monetary policy. These exogenous factors were first defined at the end of 1998 (see the January 1999 Inflation Report) and extended in April 2001 (see the April 2001 Inflation Report). The factors are:
- major deviations in world prices of raw materials, energy-producing materials and other commodities;
- major deviations of the koruna's exchange rate that are not connected with domestic economic fundamentals and domestic monetary policy;
- major changes in the conditions for agricultural production having an impact on agricultural producer prices;
- natural disasters and other extraordinary events having cost and demand impacts on prices;
- changes in regulated prices whose effects on headline inflation would exceed 1-1.5 percentage points;
- step changes in indirect taxes.
In connection with the Czech Republic's accession to the European Union, the set of escape clauses is also likely to include one involving one-time, difficult-to-predict price shocks associated with the adoption of EU standards (see the CNB Monetary Strategy document).
In the inflation targeting regime, the main decision-making factor regarding changes to monetary-policy instruments is any deviations of the conditional forecast from the inflation target band at the horizon of most effective transmission. There are basically two reasons for such a deviation:
- the settings of monetary policy instruments are out of line with inflationary pressures in the economy, forcing the central bank to react by changing its monetary policy instruments so as to return the conditional inflation forecast back to the inflation target band at the horizon of most effective transmission;
- in the conditional inflation forecast it is possible to identify for a given period shock changes in the exogenous factors contained in the escape clauses.
Whereas the first case requires a change in monetary conditions that will return the conditional inflation forecast to within the inflation target band, in the second case the central bank may decide to leave its monetary-policy instruments unchanged, as once the exogenous shock unwinds inflation should return to its original trajectory. Hitting the target under these conditions would probably be accompanied by excessive fluctuations in macroeconomic and monetary variables. In such a situation the Czech National Bank may opt for temporary non-fulfilment of the inflation target and apply the escape clause mechanism.
To sum up, the escape clauses will be applied in cases where the conditional inflation forecast is heading outside the inflation target range at the horizon of most effective transmission, and where the Czech National Bank, on the basis of its analyses, considers that this deviation is due to shock changes in the exogenous factors contained in the escape clauses. To explain these situations to the public, the CNB will use the Minutes of the Bank Board meetings, press conferences and Inflation Reports.
1 For details see Annex 1 of the April 2001 Inflation Report.