MONETARY POLICY REPORT | SUMMER 2021 (box 3)
(author: Tomáš Šestořád)
Inflation is affected by demand and cost factors, which are reflected in consumer prices with different lags. Knowledge of the time profile of the pass-through of these factors to end prices helps the central bank respond in time and thus fulfil its price stability mandate in the form of the 2% inflation target at the monetary policy horizon. The CNB’s monetary policy settings are based primarily on a macroeconomic forecast prepared using the g3+ core forecasting model, which captures inflation in the Czech economy on the basis of a price vertical (see Chart 1).[1]
Chart 1 – Price vertical of the g3+ core forecasting model
Note: Red indicates variables which enter the g3+ model as exogenous assumptions
Consumer price inflation is determined by net inflation, administered prices and changes to indirect taxes. The central bank sets its interest rates in the g3+ model on the basis of monetary policy-relevant inflation, i.e. consumer price inflation adjusted for the first-round effects of changes to indirect taxes, as these effects are beyond the central bank’s control and have only a short-term effect on inflation in themselves. Moreover, suppressing them could adversely affect the economy.
Administered prices consist of items with price ceilings or prices regulated on a cost-plus basis[2] and administratively fixed fees (e.g. prices of electricity and heat for households).
The key variable in the g3+ model is net inflation,[3] which reflects cost pressures both from the domestic economy and from abroad. Besides costs, net inflation includes producers’ margins,[4] which capture demand pressures in the economy.[5] If costs increase, producers can choose whether to reflect the higher input prices in higher end prices or to cut their margins. If demand is sufficient, they usually raise their prices and maintain their margins.
Net inflation depends predominantly on growth in prices of domestic inputs, which is driven mainly by domestic cost factors – wages in market sectors and the price of capital, reflecting the performance of the domestic economy. By contrast, technological progress – captured in the model as rising labour efficiency – depresses growth in costs and prices, as rising labour efficiency enables firms to make products using less labour and capital.
Domestic inflation is also significantly affected by import prices, which we divide into two components in the g3+ model.[6] First, we use energy import prices, which are determined primarily by foreign energy and commodity prices. They consist of not only the price of crude oil, but also prices of other energy sources and prices in segments closely linked with their processing.
By contrast, core import prices are driven by core foreign industrial producer prices and mainly reflect fundamental macroeconomic developments abroad (in our case the effective euro area). A rise in energy prices represents a purely inflationary cost pressure for the domestic economy, while a rise in core foreign industrial producer prices leads, all other things being equal, to an improvement in domestic exporters’ price competitiveness. This fosters appreciation of the nominal koruna exchange rate, which dampens the cost effect of higher core import prices. Both import price components are simultaneously affected by the exchange rate of the koruna against the euro. Depreciation of the koruna fosters higher import prices, leading to an increase in the domestic price level.
The price convergence that accompanies the real convergence of the performance of the export sector and the Czech economy as a whole towards euro area countries also feeds into net inflation. We use the concept of the Balassa-Samuelson effect to incorporate the impact of price convergence into growth in costs.[7] According to this concept, price convergence can be proxied by the difference between growth in non-tradables and tradables prices in the domestic economy.
The strength of the effect of the aforementioned factors on the price vertical differs, and their transmission channels vary as well. Charts 2 and 3 show the impacts of changes to selected factors on inflation and interest rates as impulse responses[8] of the g3+ model. For example, an unexpected increase in retailers’ margins is immediately reflected in prices, so the room for monetary policy response is limited. By contrast, a change in prices of cost factors feeds into final consumer prices gradually and with a lag due to price rigidities in various parts of the domestic production chain. This gives the central bank room to respond actively to the movement of costs by changing interest rates and thus avoid undesirable large deviations of future inflation from the target.
Chart 2 – Producers’ margins pass through to prices immediately and most strongly, while cost factors do so with a lag
responses, in pp, of annual monetary policy-relevant inflation to unexpected 1 pp changes in selected factors (q-o-q; annualised) in Q1; x-axis shows quarters
Chart 3 – Market interest rates go up in response mainly to an increase in foreign core prices; higher labour efficiency has the opposite effect
responses, in pp, of market interest rates to unexpected 1 pp changes in selected factors (q-o-q; annualised) in Q1; x-axis shows quarters
[1] The main features of the g3+ model are presented in a CNB blog article. A more detailed description of the model is given in the working paper Brázdik et al. (2020). The price vertical in the previous g3 prediction model was described in a box in IR IV/2008.
[2] Items whose prices may only reflect economically justified costs and a reasonable profit.
[3] Net inflation is consumer price inflation net of administered prices and adjusted for the first-round effects of changes to indirect taxes. It thus represents prices which are determined freely by the market. It is therefore sometimes referred to as market price inflation.
[4] The g3+ model assumes that firms operate in an environment of monopolistic competition. In such economic conditions, each firm has some market power (given, for example, by a type of product that is specific to some extent), allowing it to set prices by adding a margin on top of its costs and hence generate profits.
[5] In addition to the margins of final producers, the g3+ model includes the margins of domestic producers and importers. However, their effect on the resulting path of inflation is weaker than the effect of producers’ margins.
[6] The division of foreign producer prices into their core and energy components is discussed in more detail in a box in IR III/2019 describing the changeover to the g3+ model.
[7] The Balassa-Samuelson effect, as captured in the CNB’s forecasting system, is discussed in more detail in a box in IR III/2016.
[8] An impulse response is the response of a selected variable to a change in the effect of a certain factor.