Inflation Targeting
in the Czech Republic
Luděk Niedermayer, CNB Prague
EMU and the New Member States
Year after Accession
Sofia, 3 October 2005
Contents
1. Monetary policy scheme during early years of
the reform
2. Reasons for the policy change to inflation
targeting in the Czech Republic
3. Development of the framework
4. Lessons, challenges, now and ahead
www.
.cz
Environment for the monetary
policy in early 90s
• In 80s, Czechoslovakia one of the most rigid and most
heavily regulated economies in the East bloc
• Level of macroeconomic stability, private savings and
credibility of the currency relatively high
• Nominal inflation low, hidden inflation high (demand
overhang on market with state controlled prices)
• Field for the monetary policy



limited number of banks (monobank dissolved on Nov 89)
no financial markets
koruna not convertible, existence of limited black market
1st January 1991
•
•
•
•
•
Liberalization of prices
Liberalization of foreign trade
Internal convertibility of CSK (for CA transactions)
Start of privatization
Unification of exchange rates and introduction of
fixed rate against trade weighted basket
• Due to weak credibility, low capital inflows,
financing through official resources at the beginning
Monetary policy framework
• Monetary policy:



ultimate goal - monetary stability
intermediate targets - fixed exchange rate + M2x
instruments



•
auctions refinancial credits (+ emergency credits and credits
against the pledge of bills)
interest rate ceiling 24%, lending limits
FX transactions for balancing of positions of the banks
First year performance (incl. dereg. of prices):


inflation rate 56,6% (took place in Jan and Feb)
GDP growth declined to -11,6% (internal and external
reasons)
… Field for monetary policy was
gradually changing ...
•
•
•
•
Reduced uncertainty regarding
future economic course of the
country
A large number of banks
emerged
Financial markets gradually
liberalised and developed
Convertibility of koruna
deepened, regulations are
gradually lifted
20
15
10
GDP
Inflation
5
0
1993
1994
1995
1996
-5
On Jan 1, 2003, former federation CSFR was split, the CNB replaced
SBCS - former central bank of CSFR, CZK was introduced
… Leaving nominal anchor No. I …
• Since Sept 92 CNB has reduced its
FX activities and introduced band
(+/- 0,5 %)
• Both ultimate goal (monetary
stability) and intermediate target
(M2 + implicit assumption of FX
stability) unchanged
• Further liberalisation of the FX
regime and reduction of the risk
premium (OECD member since 95)
made fixed FX rate policy difficult
and costly - CPI was at high single
digit and nominal IR were high),
since February 28, 1996, band
widened to ±7,5%
CNB FX reserves (CZK)
400
350
300
250
200
150
100
50
0
1993
1994
1995
1996
May 27, 1997 – CZK is floating
•
•
•
Spill over from the Asian crises was the short term cause of
crises
Low commitment of all other policies (or even discussion
about it) to fixed FX rate and weak supply side compared to
expanding demand were the real cause. Weak corporate
governance in banking sector was important contributor to the
crises and obstacle for transmission of monetary policy
Too long existence of the regime in such an environment put
CNB in front of the difficult decision under time pressure
20
19,5
Do not stick to temporary policies
for too long!
19
18,5
18
17,5
17
16,5
16
15,5
15
1-I.
21-I.
10-II.
1-III.
21-III.
10-IV.
… discussion on new monetary
policy strategy…
• What is the goal of the monetary policy ?
• What are the tools of the CNB ?
… discussion more pragmatics …
• What is the goal of the monetary policy ?
• What are the tools of the CB ?
•
•
•
•
What are you trying to achieve ?
What tools do you use ?
How do they work ?
How do you decide ?
... options …
1. Substantial widening of fluctuation band creating a space
for more autonomous monetary policy and continuity
with previous strategy („soft“ dual target)


This solution was already partly chosen, when the band was
widened to ±7,5% . After the crises, any band will suffer from
weak credibility
Too wide band does not serve the objectives :

Too large to stabilize

Exists, so can be the source of tensions
2. Stick to monetary targets only (do not hurt but does it
work ?)…
•
•
•
Complications in execution of the policy at developed and
unregulated market
Are not reflecting actual policy of CNB
Are difficult to communicate
Marketplace for implementation of
the monetary policy
end of 90s
• Internationalization of the market, private capital flows
• Removal of most regulations, CZK convertible in practice,
latter de jure
• Money market and FX market liquid and efficient, role of
the CB on decline
• Main tools of the CNB


short term interest rate (2 W, partly 3 M)
FX rate - interventions
• Transparency demanded
Inflation Targeting
or
Targeting of the Inflation
-2.0
-7.0
M1
M2
Inflation
-12.0
O monetary target
2004Q3
2004Q1
2003Q3
2003Q1
2002Q3
2002Q1
2001Q3
2001Q1
2000Q3
2000Q1
1999Q3
1999Q1
1998Q3
8.0
1998Q1
1997Q3
1997Q1
1996Q3
o
1996Q1
18.0
1995Q3
1995Q1
13.0
1994Q3
1994Q1
... monetary targets neither
transparent or achievable …
28.0
23.0
o
o
3.0
… and the fixed FX rate is over …
18
12
depreciation
band +/-7,5%
Feb 28.1996 - May 27.1997
6
in %
band +/-0,5%
Sep 27. 1992 - Feb 2.1996
the level of ER
against the former
currency basket
(65% DEM, 35% USD)
0
-6
appreciation
-12
targeting of M2 and until
May 26, 1997 ER as well
inflation targeting
-18
1/91
1/92
1/93
1/94
1/95
1/96
1/97
1/98
1/99
1/00
1/01
1/02
1/03
1/04
1/05
… a new framework must be
implemented …
Considering pros and cons IT in CNB
• Transparency +





commitment to open and
transparent policy
more of interest of market
and media in CNB
monetary target not
transparent
call for more transparency to
build credibility after crises
„say what you do and do
what you say“
• Feasibility 


economy volatile
especially after the crises
no or weak forecasting
mechanism (risk of either
not hitting the target or
too restrictive policy)
part of CPI highly
volatile, part regulated
without medium term
strategy
IT
c
CNB Mk. I and II
• Pros > Cons, effort to reduce the risks - target is
net inflation (CPI ex. Regulated prices and tax
changes), specific „escape“ clauses
• Forecast



rely on single equation expert „models“, later on
longer end (4th Q) small macro model
monetary policy role in the forecast is very weak
creation of the „communication“ schema
IT
c
CNB Mk. III and IV
• From NI to CPI (with some assumption on growth
of regulated prices), weaker accent on exemptions
• From conditional forecast to unconditional, with
reaction function and active role of monetary
policy (since 2001)
• Gradual shortening of the short term expert
forecast to 1st Q, more of the importance of the
model (since mid 2002)
• Larger, less aggregated model under construction
CNB targets
14
13
consumer prices
12
net inflation
11
10
9
8
target 1998
6% +/- 0,5p.b.
(announced in
December 1997)
v%
7
6
target 2000
4,5 +/- 1p.b.
(announced in
December 1997)
start of the
target band
3-5%
5
target 1999
4,5 +/- 0,5p.b.
(announced in
November 1998)
4
3
end of the
target band
2-4%
target band
2002-2005
(announced
in April 2001)
point target 3%
since 2006
(announced
in March 2004)
2
target 2001
3% +/- 1p.b.
(announced
in April 2000)
1
0
1/96
-1
1/97
1/98
1/99
1/00
1/01
1/02
1/03
1/04
1/05
1/06
1/07
Framework of IT
• Target - set by CNB, government is consulted
• Instruments – ECB instrumentarium, interventions not
excluded
• Forecast


staff, model based, 4 times a year
forecast disclosed (ex. IR and precise FX)
• Transparency


press conf., minutes incl. anonymous votes /8 days/,
Inflation Report including forecast Q /8 days/
reporting 2/Y to parliament, no formal IT accountability
Example of the forecast
5
4
3
target band
inflation target
since 1/06
2
1
0
1/05
monetary
policy
horizon
inflation foreccast
4/05
7/05
10/05
1/06
4/06
7/06
10/06
Main experience
• Hitting the target - NOT OFTEN, undershoot
most of the time, despite „aggressive“ monetary
policy. Shocks (mostly FX) are partial cause
• Transparency – pretty high, appreciated by
analysts and publics (8 out of 10 mark in Reuters
pool)
• Inflation expectations – very good, close to the
target
• Better policy schema – NOT KNOWN
Challenges ahead
• Going to ERM II



too many policy changes
too many targets
some targets are not even clear
• Need likely some pragmatics policy and
shortening of the period for the minimum time
IT lessons (I)
• The discussion on the „actual“ implementation of the
monetary policy is the key for selection of the „good“
framework
• Targeting of the inflation is „natural“ choice for the
countries with relatively volatile economy. Could be
understood in less rigid sense:



Resignation on one clearly defined intermediate target
Effort to use all available information for achievement
of „desired“ price development
Promotion of the Transparency – as it enhances both
credibility of the CB and efficiency of the monetary
policy
IT lessons (II)
• Target setting in converging economy:
 how big is a need for price adjustment, how it will take
place and what is the estimate of BS effect
 equilibrium appreciation has and impact on inflation (push
down)
 falling risk premium can reduce IR autonomy (capital
inflow)
 too low rates in economy can get inflation to the target but
has intertemporal impacts (risk of over asset bubbles etc.)
• Incentives for target with some spread against the base
economy (EU) is rational. But hit such a target?
IT lessons III
• Role of the FX rate in small open economy with inflation
targeting



has impact on the forecast without doubts
so must have impact on the policy
too much of the reaction can get CB into the „FX trap“
• Role of the „volatile items“ in CPI

some items with high volatility have higher proportion in
CPI
• Reaction of exogenious shocks


Primary vs. secondary effects
Communication