MONETARY POLICY REPORT | WINTER 2024 (box 1)
(authors: Tatiana Keseliová, Tomáš Pokorný, Jan Syrovátka, Tomáš Šestořád, Stanislav Tvrz)
The CNB’s price stability mandate involves retrospectively assessing the fulfilment of its 2% inflation target and determining the causes of any past deviations of inflation from the target. This box, regularly included in the report, contains the said assessment for the last two calendar years, i.e. for 2022 and 2023.
In 2022, inflation was well above the CNB’s 2% inflation target (see Chart 1). The rate of inflation decreased gradually from double to single figures last year but remained well above the target. The factors underlying the deviation of inflation from the target were identified using the g3+ core forecasting model.[1] These factors provide an insight into the origin of the inflation pressures faced by the Czech economy in the past two years (see Chart 2).
The monetary policy rule in the g3+ model sets interest rates so as to ensure that inflation returns to the 2% target at the monetary policy horizon. The inflation outlook takes on board the forecasts for all relevant macroeconomic variables. The emphasis on the monetary policy horizon reflects the gradual transmission of interest rates to future economic developments and in turn to inflation. By concentrating on inflation at this horizon, the central bank simultaneously abstracts from short-term inflation shocks. Their impact can be controlled by monetary policy to only a minimal extent. In addition, any efforts to mitigate them quickly would cause excessive interest rate volatility, which would destabilise the economy. The monetary policy rule also includes interest rate smoothing by the central bank. Nonetheless, active monetary policy stabilises inflation at the target in the medium term. This is usually accompanied by gradual movement of interest rates towards their neutral long-run level (3%).
Chart 1 – Inflation started to decline gradually last year due to decreasing growth in corporate costs and cooler household demand amid a tight CNB monetary policy stance
consumer prices in %
Chart 2 – The deviation from the target in 2022 and 2023 was due mainly to a sharp rise in energy prices and insufficient monetary policy tightening in 2021–2022
deviation of monetary policy-relevant inflation from the CNB’s 2% target; contributions in pp
Monetary-policy relevant inflation is inflation to which monetary policy reacts in the forecast. It is defined as headline inflation adjusted for the first-round effects of changes to indirect taxes.
The record growth in foreign industrial producer prices in 2022 reflected a huge rise in energy commodity prices on global markets exacerbated by Russia’s aggression in Ukraine. Disruptions to global value chains during the pandemic acted in the same direction. Last year’s partial correction of foreign industrial producer prices, which reflected an easing of supply chain bottlenecks and a decline in exchange prices of energy commodities, reduced the inflationary effect of foreign prices. The massive rise in energy prices drove up domestic firms’ costs and, in turn, final prices of products and services. These external cost pressures thus gradually passed through to all domestic price categories. Family budgets were also squeezed, as the jump in exchange prices of energy led to record growth in administered prices, especially those related to housing.[2] The gradual fading of the energy price shock then reduced the contribution of administered prices for most of last year.
The domestic economy also had a strong inflationary effect in the past two years. This stemmed mainly from an increase in firms’ profit margins in an environment of continued solid growth in nominal household income amid still low unemployment and expansionary fiscal policy. Firms across sectors thus on average raised their prices even more than the growth in their costs implied, thereby partly making up for their previous pandemic-related losses. At the same time, however, the sharp growth in prices weakened households’ purchasing power, causing a record plunge in real incomes. The subdued consumer demand thus contributed to a gradual reduction in the inflationary effect of the domestic economy last year. In addition, the effect of the initially insufficient domestic monetary policy tightening (see also the last paragraph) faded out during 2023 amid diminishing extraordinary price pressures, with interest rates kept at elevated levels.
The ECB responded to the surge in price pressures in the euro area later and less forcefully than the CNB. The widening positive interest rate differential thus exerted appreciation pressure on the koruna, hence slowing domestic inflation. In addition to foreign interest rates, a cyclical cooling of foreign economic activity last year had an anti-inflationary effect.
The koruna exchange rate acted in the anti-inflationary direction over the entire period under assessment.[3] Although sentiment deteriorated significantly in early 2022 due to the energy crisis and the war in Ukraine, the koruna steadily appreciated owing to the positive interest rate differential, aided by actual and verbal foreign exchange interventions by the CNB. In late 2022 and early 2023, it strengthened further, mainly on the back of improved sentiment in the region due to the creation of sufficient gas stocks before the heating season. The koruna subsequently depreciated slightly last year, though to a lesser extent than implied by the narrowing interest rate differential vis-à-vis foreign interest rates. The exchange rate thus continued to slow inflation.
The Bank Board started to raise interest rates in June 2021, when it communicated the upside risks to inflation of its forecasts, which themselves had been predicting growth in interest rates for 2021 since the end of 2020. The rate hikes gained in intensity during the autumn. In the first half of 2022, the Bank Board assessed the risks and uncertainties of the CNB’s forecasts at the time mostly as significant and inflationary overall. A risk identified in the long term was that of weaker anchoring of inflation expectations in an environment of long-running overshooting of the inflation target, which could manifest itself in a wage-price spiral. The already sharp rise in energy commodity prices intensified in early 2022 due to the outbreak of the war in Ukraine. Linked with this was an increasing risk of more expansionary domestic fiscal policy (measures aimed at mitigating the impacts of the energy and refugee crises). The future monetary policy stance abroad was a significant uncertainty. In response to the exceptionally strong across-the-board inflation pressures, the CNB continued to raise interest rates until June 2022, when the 2W repo rate reached 7%. In the second half of the year, the Bank Board assessed the risks and uncertainties as being significant and going in both directions. The growing likelihood of recession abroad and a stronger-than-forecasted downturn in domestic consumer and investment demand were newly identified risks.
In 2023, the Bank Board assessed the risks and uncertainties initially as significant and going in both directions, and in the second half of the year as inflationary. Most of the previously identified risks persisted. The Bank Board communicated that the interest rate path would be higher than in the baseline scenario of the forecast. The uncertainties continued to include the future course of the war in Ukraine, the availability and prices of energy, and the future monetary policy stance abroad. In December 2023, the Bank Board cut interest rates by 0.25 pp due to a falling inflation outlook, stating that it considered it necessary to persist with tight monetary policy and approach potential further rate cuts with caution.
Inflation was well above the 2% inflation target over the entire period under assessment. From this perspective, it can be said with the benefit of hindsight that monetary policy should have been tighter at certain times. The roots of this can be traced back to the pre-pandemic period. Rates should have fallen less during the pandemic and then started to rise earlier and faster at the first sign of renewed inflationary pressures. This view takes into account the standard monetary policy horizon (12–18 months ahead). During 2022, however, the CNB temporarily considered more distant monetary policy horizons (18–24 months and 15–21 months) in its forecasts. This reflected the mostly supply nature of the inflationary shocks and the need to partially exempt their effects.
[1] The g3+ core prediction model is used to prepare the CNB’s macroeconomic forecasts. It is also employed to assess the fulfilment of previous forecasts and to determine the sources of deviations of the actual figures from the forecasts under assessment and the inflation target. For details, see The g3+ Model: An Upgrade of the Czech National Bank’s Core Forecasting Framework, CNB WP 7/2020.
[2] The deviation of inflation from the target narrowed temporarily at the end of 2022 following the adoption of a government measure to counter the high energy prices (the energy savings tariff). Due to its base effect, this measure conversely caused the disinflation process to halt temporarily in 2023 Q4, when annual administered price inflation – and hence also headline inflation – surged temporarily.
[3] The contribution of the exchange rate captures the part of the evolution of the exchange rate that cannot be explained by other variables. Thus, if, for example, the koruna depreciated, but less than in line with other macroeconomic variables, the contribution of the exchange rate is assessed as anti-inflationary.