Using the exchange rate as an instrument to ease the monetary conditions

The global financial and economic crisis forced many central banks to start using extraordinary (sometimes referred to as non-standard or unconventional) monetary policy instruments. The Federal Reserve, the Bank of England and the European Central Bank launched asset purchases and massive provision of liquidity into the economy. The Swiss central bank de facto fixed a minimum exchange rate of the franc against the euro by intervening in the foreign exchange market. Up to now, the CNB has used its standard monetary policy instruments to dampen the impacts of the financial crisis and subsequently also the debt crisis on the Czech economy. It gradually lowered its key interest rates to technical zero in autumn 2012. However, the latest macroeconomic developments necessitate a further easing of monetary policy by the CNB. For this reason, the CNB has started to use the exchange rate as an additional monetary policy instrument in order to keep inflation close to the CNB’s target and expedite a return to a situation where the CNB will again be able to use its standard tool, i.e. interest rates.

The exchange rate was selected from the relatively wide range of possible instruments back in autumn 2012, because, in a small open economy, weakening the exchange rate of the koruna is an effiective tool for raising import prices and thus also the domestic price level, and for stabilising inflation expectations close to the CNB’s target. To a lesser extent, a weakening of the exchange rate also boosts domestic economic activity. The rise in import prices can be expected to reduce households’ purchasing power, but their demand may be redirected towards domestic goods and services to a greater extent and additionally supported by lower real interest rates as a result of higher inflation expectations. At the same time, the weaker exchange rate will support Czech exports and the profitability of corporations and their willingness to invest. The recovery in production will then contribute to a rise in employment and wages, which will increase the purchasing power of households. The above impacts of exchange rate changes on the Czech economy are quite well mapped from the CNB’s point of view. In addition, according to analyses conducted using the CNB’s forecasting system, the impacts of exchange rate changes can be expected to be stronger than usual if the koruna exchange rate is used as a systematic monetary policy instrument given the zero lower bound on interest rates.

The alternative scenario contained in this Inflation Report took into account the fact that the scope for lowering monetary policy rates had been exhausted on reaching technical zero (0.05%). Consistent with this limitation, it is impossible to lower 3M PRIBOR market interest rates below technical zero plus the risk premium between PRIBOR rates and the 2W repo rate. In the alternative scenario, the exchange rate of the koruna takes over the stabilising role of monetary policy. The future evolution of the exchange rate reflects the CNB’s presence in the foreign exchange market, in line with the Bank Board’s decision of November 2013 to start using the exchange rate as an additional instrument for easing the monetary conditions. In the alternative scenario, the exchange rate weakening to CZK 27/EUR accelerates the return of inflation towards the CNB’s 2% inflation target and allows for an earlier exit from the zero lower bound on monetary policy interest rates. As before, the Bank Board may asses this forecast scenario from the perspective of the risks it perceives and take this assessment into account in its decision on the necessary exchange rate weakening. The level close to which the CNB will maintain the exchange rate will be publicly announced on the day the decision is made.