M. Singer – Czech Republic: Current Situation and Outlook 1 M. Singer – Czech Republic: Current Situation and Outlook 1 M. Singer – Inside or Outside the Euro Area 1 M. Singer – Recent Developments in the Czech Economy, Risks and Outlook 1 M. Singer – Macroeconomic developments, monetary policy and financial sector 1 M. Singer – The Czech economy and crisis in Eurozone: CNB view 1 M. Singer – Czech economy and development in Europe: Outlook and Challenges 1 M. Singer – Czech Republic: Can record low rates be sustained? 1 M. Singer – Czech Republic: Future challenges and opportunities 1 M. Singer – Present Conditions, Monetary Policy and Outlook in Czech Republic 1 M. Singer - Czech Republic: Staying Ahead of the Curve with Regard to Monetary Policy 1 M. Singer: The economic and financial crisis from the point of view of the Czech banks 1 M. Singer: Financial Crisis: Impacts on the CR and Lessons for the Supervisors 1 M. Singer: Financial Crisis: Likely Impacts on the CR and Lessons for the Supervisors M. Singer: Present Conditions, Monetary Policy and Outlook for CR 1 M. Singer: Consumer protection in financial services: CNB approach 1

From a Peg to Inflation Targeting: CNB Experience

High-level Seminar on the Benefits of Adopting a Structured Approach to Policy Analysis

Rabat, Morocco, 21 May 2015

Miroslav Singer Governor, Czech National Bank

M. Singer – From a Peg to Inflation Targeting: CNB Experience 2

Overview • Period of fixed exchange rate (1991–May 1997)

Initial period of stability of ER framework (1991–1995) Gradual erosion of consistency of MP framework and

speculative attack against peg (1995–May 1997) • Interim period (May 1997–Dec 1997) • Inflation targeting (1998 onwards)

FX interventions used to mitigate excessive ER volatility (Jan 1998–7 Nov 2013)

ER as monetary policy tool: inflation targeting at ZLB (7 Nov 2013 onwards)

The Czech Republic has historical experience both with a fixed rate and with inflation targeting

M. Singer – From a Peg to Inflation Targeting: CNB Experience 3

Koruna exchange rate: two regimes

Jan 1991–May 1997: fixed exchange rate Jan 1998–now: inflation targeting

Source: CNB

M. Singer – From a Peg to Inflation Targeting: CNB Experience 4

Initial period of fixed exchange rate (1991–1995)

• Fixed exchange rate was chosen at start of economic transformation of former Czechoslovakia in 1991

• Fixed exchange rate was supposed to provide (and did provide) economy with nominal anchor – one of few anchors available at that time when everything was unstable

• Fixed rate helped stabilise inflation and even fostered modest disinflation

The fixed exchange rate was very useful and stabilising for the initial phase of economic transformation

M. Singer – From a Peg to Inflation Targeting: CNB Experience 5

Inflation in Czech Republic (1993–2014)

Despite much higher original expectations at the beginning of 90s, inflation quickly stabilised on single digit level and during 1994–1997 oscillated between 8.5% and 10%

Source: CZSO

M. Singer – From a Peg to Inflation Targeting: CNB Experience 6

Overheating in mid-1990s: causes • Strong demand

High growth of wages (much higher than productivity growth) High growth of private and public investment (ecology and infrastructure) Strong credit growth Rather easy access to credits by private firms Loose license policy, weak and unexperienced banking supervision

Strong capital inflow (high interest rate differential) → sterilisation • Weak supply side (under-developed markets, badly-defined property rights,

malfunctioning legal and institutional framework, etc.) Emergence of external imbalance

In 1996–1997 the overheating started to become unsustainable: the situation required adjustment and policy responses

M. Singer – From a Peg to Inflation Targeting: CNB Experience 7

Erosion of MP framework (1995-May 1997) • Fixed exchange rate since 1991

(different baskets: initially five currencies; later on DEM and USD) • Monetary targeting:

Operational target: monetary base Medium-term target: M2

• Capital account liberalisation (basically finished in 1995) (driven by entry to OECD in October 1995)

• Emergence of “Impossible Trinity” = parallel existence of: a) free capital flows b) fixed exchange rate, c) independent monetary policy

Capital account liberalisation eroded the monetary framework; economy was caught in the textbook case of Impossible Trinity trap

M. Singer – From a Peg to Inflation Targeting: CNB Experience 8

Vicious circle of monetary policy in 1995-1997

M. Singer – From a Peg to Inflation Targeting: CNB Experience 9

Towards speculative attack

• To deal with imbalances some policy actions were adopted: Increase in interest rates (beginning of 1996) Widening of koruna fluctuation band (end of February 1996

± 7.5 %) 1st stabilisation package in April 1997

However: this was not enough to calm the markets! → speculative attack (in May 1997) → 1/3 of foreign reserves

used → abandonment of peg → managed float → depreciation of koruna → inflationary expectations → inflation

Marginal remedies of Impossible Trinity situation were further penalised by markets

M. Singer – From a Peg to Inflation Targeting: CNB Experience 10

Interim period: May–Dec 1997 • 2nd stabilisation package in June 1997:

Macroeconomic measures: fiscal tightening, wage freeze, import deposits (acted rapidly)

Microeconomic measures: legal and institutional reforms (more time-consuming)

• Macro- and microeconomic consequences: Negative economic growth in 1997 and 1998 Exchange rate depreciation + increased ER volatility High inflation expectations increased inflation + increased

volatility of inflation Growing problems in enterprise sector (cash crunch, low or negative

profitability, inter-enterprise arrears, lower budget revenue) • Political crisis (fall of government in November 1997)

After speculative attack on currency : fuzzy monetary framework (discretionary decision-making)

M. Singer – From a Peg to Inflation Targeting: CNB Experience 11

Inflation targeting: 1998 onwards

M. Singer – From a Peg to Inflation Targeting: CNB Experience 12

Beginnings of inflation targeting • CNB switched to IT under pressure of loss of ER peg and in

situation of elevated inflation, ER and financial uncertainty • In 1998, Board and staff started to acquire first experience:

Staff had very limited experience with inflation forecasting Information on Board’s decisions was published only after

decision was made (no fixed time meetings schedule) Main source of expertise was Bank of England

• During first few years of IT quarterly inflation reports were significantly backward-looking: they chiefly described developments in past quarter and provided only sketchy idea about CNB’s view of future

The original form of IT was very rudimentary (especially from today’s perspective)

M. Singer – From a Peg to Inflation Targeting: CNB Experience 13

“Net inflation” targeting • Net inflation was targeted as from 1998 • Targeting of net inflation (headline inflation net of

administered prices) was justified in early phase of IT by high level of uncertainty about speed and size of administered price changes initiated mostly (but not solely) by government

• Problem: net inflation was difficult concept to explain to public (few people understood it even after three years)

• Conceptually, net inflation made it very difficult to guide inflation expectations

In 2002 the CNB switched from targeting net inflation to targeting headline inflation, which has been much easier for the public to understand

M. Singer – From a Peg to Inflation Targeting: CNB Experience 14

CNB inflation targets

The net inflation targets were set for December only, whereas the headline inflation targets were continuous

M. Singer – From a Peg to Inflation Targeting: CNB Experience 15

Disinflation path of inflation targets

• Inflation targets were initially set declining to achieve disinflation

• Only in 2006 did CNB switch to horizontal inflation targets, i.e. targeting of constant inflation (headline inflation target was 3% ± 1 p.p.)

• In 2010 inflation target was lowered to 2% ± 1 p.p. • Current target is consistent with price stability for advanced

economies; this target will not be changed – will stay in force until euro is adopted

The IT disinflation process lasted from 1988 until the end of 2009, i.e. 12 years

M. Singer – From a Peg to Inflation Targeting: CNB Experience 16

Escape clauses story 1/2

• In Nov 1998, a few months after introduction of IT, CNB announced four ex ante exceptions from fulfilling inflation target: major deviations in world prices of raw materials, energy-producing

materials and other commodities from their predictions major deviations of Czech koruna’s exchange rate from its

prediction which are not connected with domestic economic fundamentals and domestic monetary policy

major changes in conditions for agricultural production having impact on agricultural producer prices

natural disasters and other extraordinary events having cost and demand impacts on prices

Escape clauses were adopted given unexpected undershooting of inflation targets for 1998 and 1999

M. Singer – From a Peg to Inflation Targeting: CNB Experience 17

Escape clauses story 2/2 • Following switch from net inflation targeting to headline inflation

targeting, set of escape clauses was expanded to include: changes in regulated prices whose effects on headline inflation would

exceed 1–1.5 p.p. a year step changes in indirect taxes

• In subsequent years, escape clauses were applied unsystematically and on borderline between ex post and ex ante approaches

• Economic reality and monetary policy communication were too multifaceted to allow issue of escape clauses to be resolved in advance with simple list

• Latest application of escape clause: slump in oil prices in late 2014/early 2015

The adoption of escape clauses implied a switch to flexible IT. However, after long process of attempts to fine-tune escape clauses wordings no systematic itemized list of escape clauses is currently used.

M. Singer – From a Peg to Inflation Targeting: CNB Experience 18

Forecasting techniques • After introducing IT CNB relied on short-term expert forecasts (learning

process); CNB forecasting system was opaque to public (and as a matter of fact to Bank Board too)

• Introduction of “QPM” (Quarterly Projection Model) in mid-2002: Put whole forecasting process on much firmer and well-structured footing Integrated modelling approach and short-term forecast (only for next quarter) Switched from assumption of constant interest rates (“conditional forecast”)

to model with endogenous rates (“unconditional forecast”) Performance needed improvement chiefly in the exchange rate area

• Introduction of “g3” in July 2008 Reliability of forecasting techniques decreased during financial crisis

(forecasts were supplemented more with expert judgement) Despite all criticism of this class of models DSGE model has shown its better

qualities than QPM and performs better as analytical and forecasting tool at zero lower bound (ZLB)

The CNB currently uses one of the most advanced modelling frameworks in the central banking world

M. Singer – From a Peg to Inflation Targeting: CNB Experience 19

Increasing transparency • CNB has been systematically increasing its monetary policy

transparency over the years • Efforts have been based on conviction that pursuing open,

comprehensible, accountable and therefore credible monetary policy is essential part of fulfilling its statutory mandate

• Many different actions have included: disclosure of voting ratios in votes on policy interest rates (since 2001) introduction of regular meetings with analysts (since 2005) publication of forecast-consistent interest rate path in form of fan chart

(since 2008) publication of forecast-consistent exchange rate path in form of fan chart

(since 2009) publication of Graph of Risks to Inflation Projection (since 2011)

The CNB is currently one of the most open central banks in the world (e.g.: Fracasso, Genberg, Wyplosz (2003) How Do Central Banks Write?)

M. Singer – From a Peg to Inflation Targeting: CNB Experience 20

Undershooting of targets • For net inflation (examples): by 3.8 p.p. in Dec 1998, by 2.5 p.p. in

Dec 1999 and by 0.5 p.p. in Dec 2000 • For headline inflation: by 3.1 p.p. in 2003 Q1 • Undershooting of inflation targets had variety of causes:

Anti-inflationary shocks: shocks to agricultural producer prices (in short run) exchange rate and its shocks were ignored in interest rates setting

Forecasting system and interest rate decision-making: excessively restrictive monetary policy wrong settings of equilibrium variables ex post non-fulfilment of some exogenous assumptions combined with

unexpected shocks inaccurate description of some behavioural linkages in model

IT started with dramatic target undershooting significantly impairing growth

M. Singer – From a Peg to Inflation Targeting: CNB Experience 21

Undershooting was most pronounced in 1998–2003

Inflation targets and inflation (Jan 1998 – Dec 2014)

M. Singer – From a Peg to Inflation Targeting: CNB Experience 22

Exchange rate volatility

• In 1997–2003 foreign exchange interventions: to suppress too fast appreciation, later to suppress volatility

• Appreciation: in July 2002: 12% (wrong monetary policy!), in July 2008: 17% y-o-y; depreciation in Feb 2009: 12%

M. Singer – From a Peg to Inflation Targeting: CNB Experience 23

Monetary policy since autumn 2012

In November 2012, the CNB completely exhausted its main monetary policy instrument, i.e. interest rates

• In autumn 2012 CNB announced that if it became necessary to ease monetary conditions further, it would do so by weakening exchange rate of koruna

• In November 2012 CNB: lowered its key interest rates to “technical zero” (ZLB) no further

easing of monetary conditions was possible via interest rates halted sale of yields on its forex reserves

• During 2013 CNB made verbal interventions to weaken koruna verbal interventions had some effect (tenths of koruna) for roughly one year they delivered unusually stable exchange rate in

historical terms but effectiveness of interventions gradually faded

• Forward guidance was introduced in March 2013: “Interest rates will remain at current levels (i.e. at technical zero) over longer horizon until inflation pressures increase significantly”

M. Singer – From a Peg to Inflation Targeting: CNB Experience 24

2013: strengthening disinflation • Czech economy was more subdued than any of its neighbours • Estimates of output gap were strongly negative in mid-2013 • Decline in fixed investment lasting more than two years • Lowest-ever wage growth in private firms • Falling inflation in euro area further ECB interest rate cuts • Price declines: PPI in manufacturing, construction, services, agr. • Even excluding expected decline in energy prices, price index

would not have been positive without CNB intervention • Inflation expectations had fallen to historical lows • Household deposits per capita: +33% during 2008 Q1–2013 Q3 • Falling growth of monetary aggregates and velocity of money • Several-year-long general fall in property prices

The constantly rising disinflation risks were indicating an ever increasing decline in inflation well below the inflation target and increasing risks of deflation

M. Singer – From a Peg to Inflation Targeting: CNB Experience 25

The Bank Board’s decision of 7 November 2013

• CNB weakened koruna to around CZK 27/euro (roughly equivalent to cutting rates by 1 percentage point)

• Expressed (one-sided) exchange rate commitment: to prevent excessive appreciation of koruna below CZK 27/euro on weaker side of CZK 27 level to allow exchange rate to float

according to supply and demand on foreign exchange market change of floor not ruled out!

• Weakening of the koruna was aimed at: averting real threat of deflation attaining inflation target earlier helping economy to recover faster exiting zero interest rate level earlier (and returning to use of main

monetary policy instrument sooner) The exchange rate became a new tool in the IT regime

M. Singer – From a Peg to Inflation Targeting: CNB Experience 26

CZK/EUR exchange rate (2/1/2008–18/5/2015)

The koruna has been on the weaker side of the exchange rate commitment since it was announced, no interventions after initial weakening needed

Source: Eurostat, CNB

M. Singer – From a Peg to Inflation Targeting: CNB Experience 27

CNB monetary policy after November 2013 – use of forward guidance

The exchange rate commitment has been extended several times since November 2013

• 17/12/2013: “CNB will keep exchange rate close to CZK 27/EUR at least until early 2015”

• 26/6/2014: “Bank Board stated that CNB would not discontinue use of exchange rate as monetary policy instrument before 2015 Q2”

• 31/7/2014: “CNB will not discontinue use of exchange rate as monetary policy instrument before 2016”

• 17/12/2014: “Deflationary pressures from abroad are currently associated largely with positive supply shock, in particular fall in energy commodity prices; only if there were to be long-term increase in deflation pressures capable of causing slump in domestic demand, renewed risks of deflation in Czech economy and systematic decrease in inflation expectations, would it be necessary to consider moving exchange rate commitment to weaker level”

• 5/2/2015: “CNB will not discontinue use of exchange rate as monetary policy instrument before second half of 2016”

• 26/3/2015: “Probability of moving exchange rate commitment has increased compared to previous Bank Board meeting”

M. Singer – From a Peg to Inflation Targeting: CNB Experience 28

Weakening of koruna: impact on Czech economy

• Key macroeconomic variables are doing much better than they were before November 2013

• Weakening of koruna was one of reasons for economic turnaround (impact on growth in 2014: weakening of koruna 0.9 p.p., fiscal impulse 1.2 p.p., growth in Eurozone 0.6 p.p.)

• Had koruna not been weakened, GDP would have risen by 0.4% in 2014 and inflation would have been below -2% at end of 2014

• Exchange rate commitment implied unusually stable koruna

The weakening of the koruna prevented deflation and helped the economy to recover

M. Singer – From a Peg to Inflation Targeting: CNB Experience 29

Summary 1/2 • Currency peg (despite relatively high inflation) was initially

serving as anchor for economy undergoing systemic changes • Consistency of fixed peg was undermined by gradual

liberalisation of capital account • Late exit from peg was mainly caused by domestic policies, and

currency turbulence led to economic crisis of 1997–1998 • Inflation targeting framework at CNB has undergone enormous

changes since its adoption in 1998 has long been full-fledged and rather sophisticated framework

• Positive: successful disinflation, anchoring of inflation expectations contributed to macroeconomic stabilisation of Czech economy facilitated long-term real and nominal convergence of Czech

economy to developed economies flexible IT framework allowed us to add exchange rate to list of

instruments used to ease monetary conditions

M. Singer – From a Peg to Inflation Targeting: CNB Experience 30

Summary 2/2 • Negative:

Frequent undershooting of targets (in 1998–2003, 2007–2008 and 2011–2014)

Relatively high volatility of exchange rate • Lesson from 2002: Monetary policy must be aware of risk of

float and cannot behave as if exchange rate does not exist • In November 2013 exchange rate became new tool in IT regime • CNB joined other central banks using unconventional monetary

policy instruments in conditions of low inflation and deflationary risks

• CNB regards use of exchange rate as MP tool as success The IT regime has functioned as a consistent decision-

making framework, proving effective not only at the height of the financial and economic crisis but also at the time of the risk of deflation

M. Singer – From a Peg to Inflation Targeting: CNB Experience 31

Miroslav Singer Czech National bank

Na Příkopě 28 115 03 Praha 1

miroslav.singer@cnb.cz Tel: +420 224 412 000