Inflation Targeting Inflation Targeting in the Czech Republicin the Czech Republic

Luděk Niedermayer, CNB PragueEMU and the New Member States

Year after AccessionSofia, 3 October 2005

ContentsContents

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 Environment for the monetary policy in early 90spolicy 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 19911st 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 frameworkMonetary 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 Field for monetary policy was gradually changing ...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

On Jan 1, 2003, former federation CSFR was split, the CNB replaced SBCS - former central bank of CSFR, CZK was introduced

-5

0

5

10

15

20

1993 1994 1995 1996

GDP

Inflation

… … Leaving nominal anchor No. I …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)

0

50

100

150

200

250

300

350

400

1993 1994 1995 1996

May 27May 27,, 1997 1997 – CZK is floating– 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

Do not stick to temporary policies for too long!

15

15,5

16

16,5

17

17,5

18

18,5

19

19,5

20

1-I. 21-I. 10-II. 1-III. 21-III. 10-IV.

… … discussion on new monetary discussion on new monetary policy strategy…policy strategy…

• What is the goal of the monetary policy ?• What are the tools of the CNB ?

… … discussion more pragmaticsdiscussion 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 …... 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 implementationMarketplace for implementation of of the monetary policythe monetary policy

end ofend of 90s 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 TargetingInflation Targetingoror

TTargeting of the argeting of the IInflationnflation

... monetary targets neither ... monetary targets neither transparent or achievable …transparent or achievable …

-12.0

-7.0

-2.0

3.0

8.0

13.0

18.0

23.0

28.0

1994

Q1

1994

Q3

1995

Q1

1995

Q3

1996

Q1

1996

Q3

1997

Q1

1997

Q3

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

2002

Q1

2002

Q3

2003

Q1

2003

Q3

2004

Q1

2004

Q3

M1 M2 Inflation

o oo

O monetary target

… … and the fixed FX rate is over …and the fixed FX rate is over …

-18

-12

-6

0

6

12

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

in %

depreciation

appreciation

targeting of M2 and until May 26, 1997 ER as well

inflation targeting

band +/-0,5%

Sep 27. 1992 - Feb 2.1996 the level of ER against the former currency basket

(65% DEM, 35% USD)

band +/-7,5%Feb 28.1996 - May 27.1997

… … a new framework must be a new framework must be implemented …implemented …

Considering pros and cons IT in CNBConsidering 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 CNB Mk. I and IIIT 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

c

IT CNB Mk. III and IVIT 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

c

CNB targetsCNB targets

-1

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

1/96 1/97 1/98 1/99 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07

v %

consumer prices

net inflation

start of thetarget band

3 - 5 %

target band2002-2005(announcedin April 2001)

end of the target band

2 - 4 %

target 1998 6% +/- 0,5p.b.(announced in

December 1997)

target 1999 4,5 +/- 0,5p.b.(announced in

November 1998)

target 2000 4,5 +/- 1p.b.

(announced in December 1997)

target 2001 3% +/- 1p.b.(announcedin April 2000)

point target 3%since 2006

(announced in March 2004)

Framework of ITFramework 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 Example of the forecastforecast

0

1

2

3

4

5

1/05 4/05 7/05 10/05 1/06 4/06 7/06 10/06

monetary policyhorizon

inflation foreccast

target bandinflation target

since 1/06

Main experienceMain 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 aheadChallenges 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 lIT lessonsessons (I) (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 lIT lessonsessons (II) (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 lIT lessonsessons III 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