Monetary Policy and Financial Stability in Small and Emerging Economies:

Flexibility and Reflectiveness Do Pay Off Jan Frait

Executive Director Financial Stability Department

Centre for Central Banking Studies (CCBS) Workshop for Heads of financial stability

24 February 2015

What Is This Presentation Focusing On?

• Potentially adverse impact of major central banks‘ monetary policies on small and emerging economies gained plenty of attention following policy move by the Fed in summer of 2013*. • this was not a new phenomenon, it was just more apparent than before, • the impacts of pre-crisis policies were equally difficult to cope with.

• Central bankers in small and emerging economies: • being event-takers (or price-takers) often do not have a chance to opt for

the first-best policies owing to external conditions set by the macroeconomic policies in major advanced economies,

• must therefore be less orthodox, more flexible and rather smart to succeed,

• the optimal way of making monetary and macroprudential policies may vary over time as external conditions set by policies in large economies change,

• occasionally, steps that do not look intuitive may constitute the best reaction (though still being only second best).

2

* Shin, H.S. (2013): The Second Phase of Global Liquidity and Its Impact on Emerging Economies, remarks at 2013 Federal Reserve Bank of San Francisco Asia Economic Policy Conference.

I. Monetary Policy and Financial Stability

Challenges in the Pre-Crisis Times

4

Benign Neglect vs. Small Economies Literature

• In the pre-crisis era the benign neglect view gained a robust position in the deliberations of central bankers all over the world despite its U.S.-centric perspective.

• Still, in the discussions of central banks in small and emerging economies, more structured views could have been found. • this was due to the necessity of taking the exchange rate into account.

• The classical extension of the orthodox (i.e. U.S.-based) work on the small open economy case was Cecchetti et al. (2000, 2002): • in the context of a small-scale macroeconomic model with exchange rate

determination, the degree of inflation and output volatility was diminished by directly reacting to the exchange rate misalignment,

• since the result may be model-specific, monetary policy reactions to the exchange rate should be conditioned by the underlying sources of these movements.

5

What Benign Neglect Seemed to Ignore

• Central banks in small and emerging economies were much more supportive of the views of the leaners/BIS in the pre-crisis boom accompanied by appreciation pressures (2005 example*):

• What if a bubble emerges without any signs of inflationary pressures? • inflation measured in terms of consumer prices has not always signalled

that imbalances have been building up in the economy. • Scenario for a small open economy:

• high economic growth → excessively optimistic expectations → nominal appreciation of the domestic currency → very low inflation can prevail even under rapid credit growth and asset price acceleration for rather a long time → when open inflation pressures finally appear, it may be too late for monetary policy to react.

* Frait, J.-Komárek, L. (2005): Monetary Policy and Asset Prices: What Role for Central Banks in New EU Member States? Conference paper, published in Prague Economic Papers, Vol. XVI, No. 1, 2007.

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Scenario with Sustained Currency Appreciation

• The scenario with much more appreciation pressures turned out not to be only a matter of theory following 2005. • Koruna appreciated quite a lot in 2007-2008.

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Benign Neglect vs. Small Economies in Practice

• With hindsight, both pre-crisis developments and post-crisis experience confirmed the importance of exchange rate movements as a crucial component of both monetary and financial conditions.

• The countries in which central banks responded to exchange rate pressures broadly and pragmatically in a flexible inflation-targeting logic that were performing quite well in terms of price and financial stability*.

• Such response to appreciation pressures in a booming economy consisted in cutting policy rates a bit, allowing simultaneously for some appreciation of the domestic currency.

* Woodford, M. (2012): Inflation Targeting and Financial Stability. Riksbank Economic Review, 2012:1.

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Currency Appreciation in the IT Economies

• The best examples in this part of the world were the Czechs and Slovaks. • In other parts Australia, Canada, Korea, Malajsia or New Zealand followed

the suite.

Currency Appreciation in Selected Economies

50

60

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110

120

1/01

1/02

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1/09

1/10

CAD/USD KRW/USDMYR/USD NZD/USDAUD/USD

60

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100

110

1/01

1/02

1/03

1/04

1/05

1/06

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1/09

1/10

CZK/EUR SKK/EUR

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Currency Appreciation as a Way to Tougher Money

• The willingness to allow the value of their currencies adjust made the overall monetary conditions relatively tough despite the low level of interest rates during the global boom. • by doing so, we avoided, to some extent, the adverse effects of the

general asymmetry of pre-crisis monetary policies, focusion on actual or near-term inflation only, no matter how the business and financial cycle evolved.

• we applied, albeit a bit unwittingly, the prescription of the BIS economists, in which a successful leaning against a credit boom requires the central bank to tighten the monetary conditions above the level consistent with fulfilment of the inflation target and reduce inflation below the inflation target.

• allowing for appreciation was a textbook response to widening positive output gap – after all, it is measured nominal appreciation of the currency that represents a direct and effective mechanism for achieving the desired counter-cyclical monetary tightening in small open economies.

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The CNB Experience with Pre-Crisis Appreciation Pressures I

• An exemplary case of an economy with sustained appreciation pressures was that of the Czech Republic. • the nominal exchange rate appreciation was certainly initially quite unpleasant

and for some rather painful. • however, exporters soon learned how to live with the tough exchange rate

conditions and factored in the future evolution of these conditions into their expectations.

• labour unions realised that currency appreciation improves the purchasing power of workers’ wages; this helped to discipline wage dynamics.

• As a consequence of the appreciation pressures, Czech inflation often undershot the inflation target.

• In such a situation, the CNB naturally had to keep its policy rate at a similar or even lower level relative to the key central banks in order to avoid a protracted and even deeper undershooting of its target. • in reality this policy served more as a shield against risks from the external

environment. • how could that be?

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0

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1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 1/11 1/12 1/13 1/14

In %

Headlime inflation MP - relevant inflation

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The CNB Experience with Pre-Crisis Appreciation Pressures II

Inflation vs. inflation targets in the Czech Republic

• The CNB‘s forecasts in late-2013 were suggesting a risk of protracted undershooting of the inflation target (or even deflation).

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The CNB Experience with Pre-Crisis Appreciation Pressures III

Policy interest rates in the Czech Republic

0

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6

1/02 7

1/03 7

1/04 7

1/05 7

1/06 7

1/07 7

1/08 7

1/09 7

1/10 7

1/11 7

1/12 7

Lombard rate2W repo rateDiscount rate

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Strong Currency and Low Policy Rates as a Financial Stability Tool? I

• In a booming economy, currency appreciation can contribute to financial stability especially via reducing risk-taking through a “favourable” nominal illusion: • an appreciating currency will decrease the growth rate of nominal income,

which may restrict over-optimism regarding its future trend, which can, in turn, slow growth in demand for credit.

• under such an “illusion” households will compare low interest rates with slow growth in nominal income, all expressed in the domestic currency.

• Seemingly, sustained currency appreciation should create an incentive for households to borrow in a currency that is becoming cheaper over time, i.e. in foreign currency. • nevertheless, the people are not that rational, they “suffer” from nominal

illusions: the share of foreign currency loans provided to households has been lowest in two countries with a history of profound and sustained nominal currency appreciation – the Czech Republic and Slovakia.

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Strong Currency and Low Policy Rates as a Financial Stability Tool? II

• There may be other factors specific to a small open economy at play too: • if the economy is export-oriented, sustained exchange rate appreciation may

work against the formation of overly optimistic expectations in the corporate sector, which tames the potential for credit-enabled excessive investment and creation of unprofitable capacities.

• it may also shift part of the existing domestic demand from nontradables to tradables along a long-term trend towards higher consumption of nontradables, thus contributing to more balanced macroeconomic and structural dynamics.

• The idea of using a policy of low interest rates to shield the country from risks stemming from developed countries’ policies may sound strange.

• This was not a strategy for any central bank any time, just a specific strategy of some central banks for strange times.

• The “global monetary” scene in the pre-crisis years was strange indeed.

II. Monetary Policy and Financial Stability

Challenges in the Post-Crisis Times

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Economic activity – headwinds and tailwinds (then)

• In 2012-2013, the economy faced significant headwinds from foreign demand (EA sovereign crisis), domestic fiscal consolidation, as well as from very weak consumer and business confidence.

• Monetary conditions were loose: zero interest rates, forward guidance and verbal FX interventions, but not enough to offset the headwinds.

Foreign demand

Fiscal policy

Confidence

Monetary conditions

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Zero Lower Bound (ZLB)

• The forecast in November 2013 implied a significant decline in market interest rates well below zero, which would require 4 further rate cuts.

• Given the zero lower bound (ZLB) on interest rates, this pointed to a significant need to ease monetary policy using other instruments: • ”The CNB will intervene on the FX market to weaken the koruna so that the

exchange rate is close to CZK 27/EUR.“

3M PRIBOR (in %)

CZK/EUR and 2W REPO (in %)

The ZLB was reached in November 2012

25,0

25,5

26,0

26,5

27,0

27,5

28,0

28,5

1/13 7/13 1/14 7/14 1/15

CZK/EUR 27 CZK/EUR level

The exchange rate after the decision

• After the CNB‘s policy announcement, koruna reached 27 CZK/EUR quickly, and has been moving at somewhat weaker levels since then.

• The exchange rate volatility decreased significantly (both the actual one, and implied by futures prices), except for the most recent period.

• Actual interventions were quite massive, but took place only for a few days after the policy decision of the CNB. 18

CZK/EUR rate and CNB commitment CNB forex transactions under IT

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1/98 1/00 1/02 1/04 1/06 1/08 1/10 1/12 1/14

mil

EUR

CZK

per

1 E

UR

interventionsale of forex reserves yieldsbuy-up from Privatisation Account to forex reservesCZK/EUR

3560 mil

EUR

7499 mil

EUR

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Economic activity – headwinds and tailwinds (now)

• Currently, fiscal policy has become broadly neutral, foreign demand has recovered slightly and confidence has improved.

• Monetary conditions were eased further via the depreciated exchange rate and the related decline in ex ante real interest rates.

Confidence

Monetary conditions

Foreign demand

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Household credit accommodative as well

• Housing credit keeps on growing and margings from housing loans still declining.

Margins from housing bank loans(in p.p.)

Source: ARAD, ČNB`s calculations

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Existing loans New loans

Year-on-year credit growth to households(in %)

Source: CNB

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06/11 12/11 06/12 12/12 06/13 12/13 06/14 12/14

Households

Consumer loans

Housing loans

Consumer loans (after adjustment for one-off transfer)

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Macroprudential regulation of real estate exposures a next step?

• Property prices are rising again with gap in prices of flats moving back to positive area.

• FRS 2013/2014 (June 2014): For the eventuality of an overheating of the property market, the CNB will legislate for tools able to moderate any excessive future credit expansion.

Aggregate estimate of gap in prices of flats (in percent)

Source: CZSO, CNB, IRI and CNB calculations

-15

-10

-5

0

5

10

15

06/00 06/06 06/12

Transaction and asking prices of apartments(annual percentage changes)

Source: CZSOSource: CZSO

-20

-15

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0

5

10

15

03/09 03/10 03/11 03/12 03/13 03/14 03/15

Transaction prices (tax returns)

Asking prices

Challenges remain ...

• We learned the hard way how to cope with the impacts of loose monetary policies of major central banks in pre-crisis times. • now we are learning how to do so post-crisis times*.

• Global monetary conditions may still make the first-best monetary policy outcome (policy rates reflecting the development of economic activity and domestic inflation pressures with relative stability of the exchange rate) not available. • it may become necessary to work hard and smart to achieve the second-

best result, • swings in business and financial cycles plus euro area developments

make creative and flexible approaches inherent. • Co-ordination of monetary and macroprudential policies could be

necessary: • frequent switches in both policies may make the framework less efficient

and not so predictable.

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* Filardo, A., Genberg, H., Hofmann, B. (2014): Monetary analysis and the global financial cycle: an Asian central bank perspective. BIS Working Papers No. 463.

Thank You for Your Attention

Contact: CNB Financial Stability Department: financial.stability(at)cnb.cz CNB: Financial Stability Reports, various issues – available at http://www.cnb.cz/en/financial_stability/ Jan Frait Financial Stability Dept. Czech National Bank E-mail: jan.frait(at)cnb.cz

Some sections of this presentation are based on FRAIT, J., KOMÁREK, L., KOMÁRKOVÁ, Z. (2011): Monetary Policy in a Small

Economy after the Tsunami: A New Consensus on the Horizon? Czech Journal of Economics and Finance, 61, No. 1, pp. 5-33. http://journal.fsv.cuni.cz/mag/article/show/id/1202 .