Monetary conditions

The term "monetary conditions" is very often used in connection with the evaluation of the monetary policy settings. The monetary conditions represent the combined effect of interest rates (the interest rate component of the monetary conditions) and the exchange rate (the exchange rate component) on the economy. These are the key variables through which monetary policy can affect economic activity and, through it, inflation. In a period of easy monetary conditions monetary policy has been set in such a way as to support economic growth. If, conversely, monetary policy suppresses growth, we speak of a period of tight monetary conditions. Finally, in the case of neutral monetary policy settings, the monetary conditions are also termed neutral. The components of the monetary conditions do not necessarily affect the economy in the same direction. The interest rate component may, for example, be evaluated as relaxed and the exchange rate component as tight, or vice versa.

The interest rate component plays the primary role in determining the monetary conditions. The exchange rate component - together with numerous other effects - adjusts to interest rates: low interest rates in a given period tend to lead to disinterest in the koruna and a weaker exchange rate, whereas high interest rates have the opposite effect.

The interest rate component of the monetary conditions is made up not of short-term interest rates, which are subject to direct control by the CNB, but of long-term rates. Most firms, households and economic agents work with long-term interest rates (one-year and longer) when making decisions about their level of consumption and investment. High interest rates generally increase the attractiveness of deferring consumption and investment and of depositing any free funds in the interim on a koruna account to increase their value. This leads to weaker domestic demand, slower economic growth and a fall in inflation. By contrast, if interest rates are low it is generally better to realise one's consumption and investment plans in the given period, be it using one's own money or borrowed funds. The result is upward pressure on economic growth and inflation.

The exchange rate component of the monetary conditions represents the relative price of domestic and foreign goods, services and investment. An appreciation of the exchange rate, i.e. an increase in the relative price of domestic goods, services and investment compared to those abroad naturally leads to a shift in interest from domestic to foreign supply. The result is a decrease in domestic economic growth and downward pressure on prices of domestic goods. A depreciation of the exchange rate has opposite effects. Both main channels (interest rate and exchange rate) through which monetary policy affects economic activity are thus derived from changes in long-term rates.

It may seem at first glance that in their decisions on whether to consume and invest now or in the future, economic agents take into account observed nominal interest rates, i.e. the rates themselves. In reality, however, they usually simultaneously consider - at least in rough outline - expected price developments, since the future real value of deposited or borrowed money can be appreciably decreased or increased by inflation in the economy. The comparative advantage of consuming or investing now as opposed to deferring such activity to the future is therefore expressed by real interest rates, i.e. interest rates adjusted for expected changes in the price level. Likewise, the comparative advantage of investing in koruna assets as opposed to investing in foreign currency assets is expressed by the real exchange rate, i.e. the exchange rate adjusted for expected changes in the price level in the domestic and external economy.

So, from the economic point of view, what is important is the settings of both components of monetary conditions not in nominal, but in real terms relative to their long-term equilibrium values. If real interest rates are above their long-term level, economic agents tend to reduce their current consumption and investment and the interest rate component of the monetary conditions is assessed as tight. On the other hand, a lower level of real interest rates relative to their long-term level means an easing of the interest rate component of the monetary conditions. In the construction of the CNB forecast, the interest rate component of the monetary conditions is computed as a weighted average of three real interest rates: the one-year real PRIBOR, the real rate on newly granted loans and the one-year real interest rate in the euro area.

If the real exchange rate of the koruna against the relevant foreign currency is lower (stronger) than its long-term level, the exchange rate component of the monetary conditions is evaluated as tight. On the other hand, a real exchange rate higher (weaker) than its long-term level means an easy exchange rate component of the monetary conditions. In the CNB forecast, the exchange rate component of the monetary conditions is expressed by the koruna-euro exchange rate computed as the average for the given quarter.

In the calculation of the overall monetary conditions, the interest rate component accounts for two-thirds of the total and the exchange rate component for one-third. These weights reflect the belief that interest rates play the larger role in influencing future economic growth.