Oldřich Dědek, CNB Board Member
European Financial Congress
Sopot, 6 June 2022
Let me thank the organisers for inviting me to Sopot for the European Financial Congress. It has given me the opportunity to visit for me personally a hitherto unknown and picturesque part of Poland. My father won a holiday in Sopot in the 1950s and wrote to us describing how incredibly poor the area was. Today, I can quote the title of the well-known book by Carmen Reinhart (external link) and Kenneth Rogoff (external link): “This Time is Different”.
Prof. Jerzy Hausner, the moderator of this debate, asked the panellists to express their views about the following trilemma: how to carry out disinflation without leading to a deep recession and without causing large segments of society to become permanently poorer. Let me remind you that it is a tradition of economic theory to use the trilemma concept in the sense of an impossible trinity. There is a well-known monetary trilemma that says you can’t have exchange rate stability, free capital mobility and autonomous monetary policy all at the same time. There is also a younger financial trilemma stating that financial stability, financial integration and national financial policies are incompatible. Any two of the three objectives can be pursued, but not all three. So, should the central problem of this panel also be understood as an impossible trinity?
There is no doubt that resolving this trilemma, or at least mitigating its internal conflicts, is closely linked to the monetary policy of central banks. Allow me to start by pointing to one very well-known, unique and exciting experiment, namely the fundamentally different monetary policy behaviour of the ECB on the one hand and the central banks of the Czech Republic, Poland and Hungary on the other. The current policy rate differential is approaching 6%. This experiment is all the more spicy because the fourth Visegrad country, Slovakia, is covered by the ECB’s ultra-loose monetary policy. So, with such strikingly different approaches to monetary policy, can similar striking differences be observed in inflation? It is true that inflation is extraordinarily high in all the Visegrad countries from the historical perspective. Paradoxically, however, Slovakia has the least high inflation numbers at present. In April, the Slovak harmonised index of consumer prices published by Eurostat lagged 2.3 percentage points behind the Czech one. In the case of core inflation (calculated as an all-item index excluding energy, food and beverages) the difference was even 3%. That’s a pretty big gap to go unnoticed. Isn’t it grounds for wondering whether a policy of radical monetary policy tightening is the best cure for the current inflation?
But let’s go back to the original trilemma. Where do I personally see the conflict between the central bank’s effort to reduce inflation and the effort to avoid recession? Based on my experience with monetary decision-making at my bank, the problem lies in a conscious non-distinction between cost-push and demand-pull inflation pressures. To avoid any misunderstanding, I am not saying that our experts have not carried out a number of thorough analyses seeking to decompose the inflationary pressures into supply and demand items. Their initial estimates concluded that the ratio of these effects was roughly 50–50. Now, after the outbreak of war in Ukraine, it is perhaps 80 to 20 in favour of supply pressures. However, the majority opinion is that this distinction is mostly immaterial for monetary decision-making. Why? Because what matters, so the argument runs, is inflation expectations, which must remain anchored. The public does not care what the origin of inflation is. To keep expectations anchored, the central bank should not hesitate to shock the market with the size of its hikes in order to make it clear to everyone that it is taking its price stability mandate very seriously, whatever it takes.
Is this approach bearing fruit in real life? How well are Czech inflation expectations anchored after nine months of intensive monetary tightening? The empirical evidence is mixed. For example, opinion polls among companies reveal that inflation is expected to be almost 6% at the three-year horizon, well above the inflation target of 2%. Households’ concerns about future inflation as measured by European Commission statistics are no lower than the EU average. Only external experts are sticking to an estimate of around 2%, probably because they are aware of the size of the inflation target.
I have the following explanation for this. Taming the massive supply shocks delivered by the escalating prices of oil, gas and electricity is unarguably beyond the reach of Czech monetary policy. For the sake of clarity, the cost shocks to which our bank is exposed are price increases of 80% and 160% for electricity and gas respectively. Similarly, our monetary policy can hardly prevent these cost-push shocks from being transferred downstream when year-on-year growth in producer prices is over 20%, and in neighbouring Germany over 30%. What conclusion can the public make about the effectiveness of monetary policy when they see the steep rise in rates being accompanied by still rising inflation?
Another complication is the large amount of savings accumulated during the Covid lockdowns, when consumers could not spend their money. This cushion, which is gradually being emptied, made it easier for producers to pass their costs into consumer prices.
I am pretty sceptical that at this stage of still rising inflation, driven by unprecedented energy shocks, radical monetary policy can effectively tame the increasing inflation expectations of firms and households, that is, influence their opinion of what inflation will be at some time in the distant future. I believe we should pay attention to other indicators, in particular whether a wage-price spiral is emerging. There seems to be no great risk of this yet in the Czech economy, as real wages are expected to fall by about 6% this year. The Czech National Bank also has enough foreign exchange reserves to prevent an inflation-devaluation spiral.
To conclude, the current performance of the Czech economy signals a shift towards a positive zero rather than a slide into recession. At the same time, however, no progress has been reported on the inflation front either. The peak of inflation is yet to come, despite the steep trajectory of policy rates. I am concerned that when monetary policy responds to powerful inflationary shocks, regardless of their nature, with a shocking tightening, it makes the scenario of a positive zero turning negative with no visible impact on inflation more realistic. After all, this is the essence of stagflation – less growth at the same rate of inflation. Economic theory would describe this as a Pareto suboptimal solution.