Economic Transition:
Monetary Policy and the Role of the Central Bank
Vladimir Tomsik
Vice-Governor, Czech National Bank
OECD Seminar
October 2, 2013
Paris
Outline
• Starting Point – Macroeconomic Background and Policy
Challenges
• First Steps in the Transition Period + Split of Czechoslovakia
• Currency Crisis in 1997
• Inflation Targeting and its Development
• Current Challenge: Zero Lower Bound
2
Starting Point – Background, Main Challenges
• No financial institutions and markets
• Non-convertible currency, system of many different exchange rates
• Foreign trade and GDP plunged following the collapse of the eastern
markets, companies had problems selling their products and repaying
their loans
Main economic policy challenges
• Need to create financial institutions and markets
• Liberalization of prices (+ tax reform in 1993)
• Privatization of the state property
• Building an adequate institutional and legal framework
• Economic reforms towards market economy
• Reorientation of the trade towards Western countries
• Choice of the exchange rate and monetary policy regime
3
Main Challenges for the Central Bank
• Creation of two-tier banking system: separation of commercial bank
and central bank functions
• High inflation as a result of price liberalization and multiple devaluations
• But the push for disinflation had to be balanced with the need to reverse
the economic contraction, kick-start economic growth and improve living
standards
• 1993: split of Czechoslovakia and the federal CB, currency separation
4
Monetary Policy: First Steps in the Transition Period
• 1990: four devaluations of the Czech koruna
• Two pillars:
fixed exchange rate + money growth target
• Owing to immature financial market, direct (administrative) instruments
had to be used
– credit limits and interest rate caps
– required reserves
– short term refinancial credit
• ...only gradually indirect instruments started to be used
• Internal and external currency convertibility gradually introduced,
liberalisation of cross-border financial flows (1995 OECD entry provided
a strong incentive to proceed fast)
5
Economic Performance, Problems Arising...
Annual inflation (%)
60
price of 95% of items liberalized
+ effect of devaluations
50
40
VAT introduced
30
20
10
• Inflation peaked in 1991 after
liberalisation of prices and fluctuated
around 10%, except in 1993 when the
introduction of VAT created a one-off
inflationary impulse
• Inflation was much lower than in Poland
(hyperinflation in 1990) and in Hungary
0
1990 1991 1992 1993 1994 1995 1996
10
Real GDP growth (%)
5
0
-5
-10
-15
1990 1991 1992 1993 1994 1995 1996
• GDP growth picked up, but...
• high wage growth not covered by
productivity gains
• fast domestic demand growth
• sharp deterioration of the CA deficit
• classified loans piling up
• supply side constraints
• procyclical fiscal policy in booming years
6
Impossible Trinity
free capital flows
ER peg
autonomy
of MP
• Capital account liberalisation (1995) + ER peg + positive
interest rate differential → large foreign capital inflows
• CB absorbed excess supply of foreign exchange →
additional liquidity – vs. the money supply growth target
• Withdrawal of this excess liquidity led to growth in interest
rates which stimulated the capital inflow even more
CB interventions
liberalised capital flows
interest rate differential
fixed exchange rate
macroeconomic
and political stability
capital inflow
sterilization
trap
interest rate
acceleration
M2 growth
sterilisation
7
Currency Turmoil in 1997
• Fluctuation band widened to ±7.5%
(February 1996)
• External imbalance still worsening
• Rising problems in the banking sector
• Tension on the political scene
• Eroding confidence of foreign investors
• Contagion effect of the Asian crisis
May 1997
• Massive outflow of short-term capital
and speculative attack on the koruna
• CNB defended the currency by sharply
raising interest rates and intervening
on a massive scale
• In the end the fixed exchange rate had
to be abandoned
75
CB interest rates (%)
60
1w repo
45
2w repo
30
15
Lombard rate
Discount rate
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
120
110
Exchange rate index (%)
0.5% fluctuation band
27.9.1992 – 27.2.1996
100
90
80
7.5% fluctuation band
28.2.1996 – 27.5.1997
70
depreciation
60
appreciation
50
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
8
After the Crisis...
• After the peg was abolished, koruna depreciated → higher inflation and
inflation expectations → monetary policy tightening → higher interest
rates worsened availability of credit → slowdown in economic growth +
worsening repayment of credit
• Consequences were not dramatic in comparison to other countries with
similar shocks – exchange rate hovered only approx. 10% below the
former central parity, its impact on inflation was less than 2pp
• M2 became the only intermediate target but
• not understandable for public – need to anchor inflation expectations
• implementation problems
• Decision to adopt inflation targeting
π
9
Inflation Targeting
• Evolution of the target
• Escape clauses
• Forecasting system constantly improved and refined
• Conditional forecast → unconditional forecasts
• From 2002 QPM, from 2008 g3 (small open economy DSGE model)
• Increasing transparency:
• Press conference after monetary policy decisions
• Inflation report, Minutes, Votes of bank board members
• Publication of interest rate and exchange rate forecasts
10
Inflation Targeting – Inflation Targets
22
20
Inflation targeting
18
16
14
12
Targets for
net inflation
10
Targets for CPI
8
6
4
2
0
-2
1993 94
95
96
97
98
99 2000 01
02
03
04
05
06
07
08
09 2010 11
12
13
• First targets set in terms of net inflation (netted of regulated prices and
indirect taxes) → Targets for CPI
• Band → Point target
11
Inflation Targeting – Inflation
22
20
Inflation targeting
18
16
14
12
Targets for
net inflation
10
Targets for CPI
8
CPI
6
4
Net inflation
2
0
-2
1993 94
95
96
97
98
99 2000 01
02
03
04
05
06
07
08
09 2010 11
• Inflation gradually fell down
• Low and stable inflation, inflation expectations well anchored
• Undershooting of the target more frequent then overshhoting
12
13
12
Inflation Targeting – Main Policy Rates
20
Inflation targeting
18
16
14
12
10
Lombard rate
8
2w repo
6
Discount rate
4
2
0
1993 94
95
96
97
98
99 2000 01
02
03
04
05
06
07
08
09 2010 11
12
13
• Interest rates down to low levels
• Currently 2w repo rate at "technical" zero
13
Inflation Targeting – Economic Activity
8
Inflation targeting
7
CZ
6
5
4
3
2
EA (changing
composition)
1
0
-1
-2
-3
-4
-5
1993 94
95
96
97
98
99 2000 01
02
03
04
05
06
07
08
09 2010 11
12
• Economy hit by the world economic crisis – impact on exports and GDP
• Domestic fiscal policy tightening, pessimistic sentiment
• No financial crisis – sound financial institutions
14
Inflation Targeting – Exchange Rate
40
16
12
38
8
36
4
0
34
-4
-8
32
-12
30
-16
-20
28
-24
26
-28
-32
-36
Inflation targeting
depreciation
appreciation
24
-40
22
1993 94
95
96
97
98
99 2000 01
02
03
04
05
06
07
08
09 2010 11
12
13
• Long-run nominal appreciation trend before crisis, low inflation
• Flexible ER = adjustment mechanism (e.g. In 2008-2009 and now)
• Flexible ER + low IRs → no FX loans – financial stability preserved
15
Zero Lower Bound – What Next?
• Repo rate cut to 0.05% in November 2012
• Inflation below the target, anti-inflationary domestic pressures, further
monetary policy easing needed
• Exchange rate interventions considered
• Exchange rate channel to elevate
inflation (expectation channel)
• Liquidity surplus in the Czech
banking system → no need for
liquidity injections
• IR transmission functional
• Verbal interventions
26.2
CZK/EUR
25.8
25.4
depreciation
25.0
appreciation
24.6
10
11
2012
12
01
02
03
04
05
06
07
08
09
2013
• Income on international reserves not being sold since November
• Forward guidance:
rates will be kept at zero level in the longer term
until inflation pressures rise significantly
16
Current Forecast
6
Inflation (%)
5
6
Monetary
policy
horizon
5
4
4
3
3
2
Inflation target
MP inflation (%)
Inflation target
2
1
1
0
0
Monetary
policy
horizon
-1
-1
III/11 IV I/12 II
III
IV I/13 II
III
IV I/14 II
III
3M PRIBOR (%)
4
III/11 IV I/12 II
IV I/15
III
IV I/13 II
III
IV I/14 II
III
IV I/15
III
IV I/15
GDP growth (%)
10
8
3
6
4
2
2
0
1
-2
-4
0
III/11 IV I/12 II
III
IV I/13 II
III
IV I/14 II
III
IV I/15
III/11 IV I/12 II
III
IV I/13 II
III
IV I/14 II
17
Lessons to Be Learnt
• Impossible trinity is really impossible
• On the contrary, internally and mutually consistent economic policies
of all national authorities must be in place
• Credibility is of utmost importance (together with accountability and
transparency)
• Inflation targeting proved to be successful monetary policy regime,
also when used as disinflation strategy
• Macro stability supports (although does not guarantee) financial stability
• Flexible exchange rate has been a useful adjustment mechanism during
the crisis (and now at the ZLB also possibly a monetary policy tool)
• Thus: own currency, independent MP and flexible exchange rate are
an asset of a considerable value
18
To conclude...
During two decades...
• Successful currency separation in 1993
• Inflation targeting
• Not rigid, evolved during time
• Proved to be convenient monetary policy regime – successful disinflation,
inflation expectations well anchored
• Current challenge: Zero lower bound
• CNB one of the most open and
transparent central banks
• And one of the most trusted
institutions in the Czech Republic
19
Back-up slides
20
First decade in pictures
Annual inflation (%)
60
price of 95% of items liberalized
+ effect of devaluations
50
CB interest rates (%)
75
60
40
VAT introduced
1w repo
45
30
2w repo
30
20
15
10
Discount rate
0
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
10
Lombard rate
Real GDP growth (%)
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
120
110
5
Exchange rate index (%)
0.5% fluctuation band
27.9.1992 – 27.2.1996
100
0
90
80
-5
7.5% fluctuation band
28.2.1996 – 27.5.1997
70
-10
depreciation
60
appreciation
50
-15
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
21
Fifteen Years of Inflation Targeting
Inflation (%)
14
18
12
16
10
14
12
Targets for
net inflation
8
CB interest rates (%)
20
10
Targets for CPI
6
Lombard rate
8
CPI
4
2w repo
6
4
2
Net
inflation
0
98
99 2000 01
2
02
03
04
05
06
07
08
09 2010 11
12
13
Discount rate
0
98
99 2000 01
02
03
04
05
06
07
08
09 2010 11
12
13
12
13
-2
Real GDP growth (%)
Exchange rate (CZK/EUR)
40
7
6
5
4
3
2
1
0
-1
-2
-3
-4
-5
38
36
34
32
30
28
26
depreciation
24
appreciation
22
98
99 2000 01
02
03
04
05
06
07
08
09 2010 11
12
98
99 2000 01
02
03
04
05
06
07
08
09 2010 11
22
Current Forecast – Exchange Rate (CZK/EUR)
29
27
25
23
21
III/11
IV
I/12
II
90%
III
IV
70%
I/13
II
III
IV
I/14
50%
30% confidence interval
II
III
IV
I/15
23