MONETARY POLICY REPORT | SPRING 2021 (box 4)
(authors: Jakub Bechný, Jan Syrovátka, Tomáš Šestořád, Jan Žáček)
Maintaining price stability – the primary mandate of the CNB – involves regularly assessing the fulfilment of the inflation target and determining the causes of any past deviations of actual inflation from the central bank’s target. Such evaluations were a standard part of the Inflation Report until 2020, and since 2021 they have formed a part of its successor, the Monetary Policy Report. This approach reflects the CNB’s high degree of monetary policy transparency and the responsibility it feels towards experts and the general public.
Starting with this Report, we will once a year evaluate the deviation of monetary policy-relevant inflation from the 2% target over the previous eight quarters. The period currently under examination runs from 2019 Q2 until the start of 2021. Inflation was close to the upper boundary of the tolerance band around the CNB’s 2% target for most of the period under review, and even rose temporarily above that level (i.e. above 3%). It then dropped close to the target in late 2020 and early 2021 (see Chart 1). The results of the analysis provide a view of the origin of the inflation pressures faced by monetary policy in the past. The deviations of inflation from the target are presented in the form of a decomposition (see Chart 2) into the contributions of categories of unexpected structural shocks,[1] which were identified using the g3+ core projection model.[2]
The primary objective of monetary policy is to maintain price stability. Since January 1998, i.e. for more than 20 years, the CNB has been applying an inflation targeting regime which aims to keep inflation close to a declared target. Since 2010, the target has been set in the form of 2% year-on-year growth in the consumer price index with a tolerance band of ±1 pp. This target is in line with the practice in advanced economies.
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.
Chart 1 – Inflation was above the 2% target in the period under observation, and fell close to the target at the turn of this year
headline and monetary policy-relevant inflation in %
Chart 2 – The markedly positive deviation of inflation from the target last year was mainly due to the previous overheating of the domestic economy and the relaxed setting of monetary conditions
deviation of monetary policy-relevant inflation from CNB’s 2% target, contributions in pp
We distinguish two types of price effects in relation to changes to indirect taxes – first-round and second-round. The first-round effects are the calculated price changes due to the indirect tax changes implied by full (accounting) pass-through of the tax changes to prices of the relevant items of the consumer basket. The second-round effects capture the price changes due to indirect tax changes going beyond their first-round effects. The second-round effects may be positive or negative. In the case of a tax increase (decrease), they are positive if the prices of the items concerned rise (fall) more (less) than implied by mechanistic pass-through of the tax changes. Conversely, they are negative if prices rise (fall) less (more) than the tax increase (decrease) would imply. The CNB applies escape clauses to the first-round effects of indirect tax changes. This means that the CNB looks past them when setting its monetary policy.
Economic developments abroad have had a constant strong anti-inflationary effect in the past two years. Industrial producer prices abroad had the largest impact. They rose only moderately in 2019 and even declined in 2020. The anti-inflationary effect of the foreign environment was amplified last year by the unprecedented fall in the global economy following the outbreak of the coronavirus pandemic.
Conversely, the markedly overheated domestic economy contributed positively to the deviation of inflation from the target until the end of 2020. In 2019, its inflationary effect reflected both a sizeable increase in administered prices and continued brisk wage growth owing to significant labour market tightness. A partial cooling of the labour market occurred during 2020 when the Czech economy was hit by the adverse effects of the coronavirus pandemic. The effects of the first wave of the pandemic on the Czech economy last spring were inflationary overall, as the deterioration in labour efficiency outweighed the contraction in economic activity. However, subdued domestic demand increasingly slowed inflation in the course of 2020 due to the autumn reintroduction and tightening of government anti-epidemic measures targeted at retail and services. In early 2021, the effect of subdued domestic demand even outweighed the inflationary effect of the temporary deterioration in labour efficiency.
In hindsight, monetary policy was excessively accommodative until the end of 2020. In 2019, this reflected increased caution in the central bank’s monetary policy decision-making about further interest rate increases, owing to significant uncertainty in international trade. Before the outbreak of the pandemic, interest rates were therefore below the level consistent with the standard monetary policy reaction function. The forecast published at the start of 2020 signalled an increase in inflation above the upper boundary of the tolerance band around the target. This was mainly due to second-round effects associated with changes to indirect taxes (a VAT cut) in a situation of persisting strong fundamental inflation pressures in the domestic economy. The Bank Board raised interest rates by 25 basis points in February in line with the forecast contained in Inflation Report I/2020.
However, the calm economic and monetary situation was brutally disrupted in March 2020 by the outbreak of the global coronavirus pandemic. The anti-epidemic measures adopted worldwide affected global trade and limited social contact. This in turn had a negative impact on economic activity and the consumer and investment behaviour of households and firms. The result was a deep economic downturn both in the Czech Republic and globally, to which countries reacted through their fiscal and monetary policies. The CNB also responded to the adverse economic developments and the outlook for a decrease in inflation by cutting interest rates rapidly and sharply.[3] A significant weakening of the koruna, which worked as an automatic stabiliser (adjustment mechanism), also helped to ease the monetary conditions. It can be said that the accommodative effect of the two components of the monetary conditions offset the anti-inflationary effect of the foreign and domestic economies in early 2021.
At its meetings in 2019, the Bank Board perceived the uncertainties and risks of the macroeconomic forecasts at the time initially as balanced and later as anti-inflationary, based mainly on concerns of a more pronounced demand slowdown in the Czech Republic’s main trading partner countries. In 2020, the Bank Board repeatedly assessed the uncertainties and risks of the forecasts as being very substantial. The Bank Board considered the course of the pandemic and its economic and price effects to be the main risk. It also took into account other uncertainties relating to the reaction of domestic fiscal policy, internal policy developments in the USA, the manner of the exit of the UK from the EU and the structure of the supply and demand factors underlying inflation. The exchange rate, which was highly volatile in 2020, was also a significant uncertainty for the Bank Board.
Inflation was above the upper boundary of the tolerance band for most of 2020, owing mainly to the inertial effect of the previous overheating of the economy, and fell close to the 2% target only at the close of the year. From this perspective, it can be said that monetary policy should have been tighter in 2019. Nonetheless, its accommodative effect offset the anti-inflationary impacts of the pandemic last year. With the benefit of current knowledge of the strong effects and risks associated with the current economic situation, it can also be said that monetary policy had created sufficient room for relaxing interest rates in the pre-pandemic period, room which it used in spring 2020. As a result, the CNB, unlike other central banks, did not need to deploy unconventional monetary policy instruments. Inflation expectations remain firmly anchored to the 2% target and the CNB is fulfilling its price stability mandate.
[1] Unexpected structural shocks offer a model-based interpretation of the evolution of economic variables.
[2] The g3+ core prediction model is used to prepare the CNB’s macroeconomic forecasts, which are the key input to the Bank Board’s monetary policy decision-making. The g3+ model is also used to evaluate the fulfilment of previous forecasts and to determine the sources of deviations of the actual figures from the evaluated forecasts 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.
[3] The CNB’s measures in response to the Covid-19 pandemic were examined in greater detail in a box in Inflation Report III/2020.