Guest post by Kevin English
In an earlier post, I outlined Professor Paul Beaudry’s assessment of the current issues that many inflation-targeting (IT) central banks are facing. Beaudry pondered whether there are additional policy instruments that can be effectively added to the IT framework.
In his presentation, Douglas Laxton of the International Monetary Fund (IMF) provided a convincing argument that, indeed, there are additional policy instruments that — if used appropriately — are still consistent with an IT framework. In this last blog post on CIGI’s session at CEA 2014, we turn to the fascinating case of the Czech Republic that Laxton used to support this claim.
Like several central banks, the Czech National Bank (CNB) recently found itself facing deflationary pressures and hamstrung by the zero-lower bound on interest rates. Walloped by spillovers from the Euro zone crisis, and with domestic demand struggling to tread water, the Czech economy had endured six straight quarters of contraction (Q4-11 to Q1-13). At this juncture, forecasts consistent with achieving the bank’s inflation-output objectives called for a policy rate significantly below the effective floor.
As Laxton explained, the CNB was in a bind: without the available recourse to current and future rate reductions, its forecast showed significant risk of deflation (falling prices and a weak economy). These dynamics risked undermining the credibility of the Bank’s commitment to its Inflation-Forecast Targeting framework.
Facing this situation, many central banks have opted to engage in outright asset purchases to jump start their economies and signal their resolve to tackling the risk of deflation. The best known of these programmes, of course, is the U.S. Federal Reserve’s program of quantitative easing (QE).
The CNB weighed this option, but eventually opted not to go down the QE route. Why was this? The major reason, according to the Bank, was that the Czech financial sector was already awash in liquidity; and, as the IMF staff have noted, long-term yields on government bonds were already extremely low.
The bank had already incorporated forward guidance into its communication strategy, signalling that it was considering the use of the exchange rate tool to achieve its output and inflation objectives. Words, however, were losing their effectiveness and action was necessary.
Faced with these limitations, the CNB intervened in the foreign exchange market for the first time since 2002. On November 7, 2013, the CNB announced a new (temporary) asymmetric ceiling on the exchange rate, committing to purchase whatever volume of euro assets was necessary to weaken the koruna. The CNB communication of this decision made it clear that they were not targeting the exchange rate, but rather using the exchange rate as a complementary tool, since the policy rate was at the zero lower bound.
As Laxton detailed in his presentation, the CNB reasoned that a lower nominal exchange rate would stimulate both domestic demand and exports. This would help to close the output gap, improve labor market conditions and support wage growth, while the rising prices of imports would translate more directly into higher headline inflation.
The view was that higher import prices would eventually help underpin an acceleration of underlying inflation towards the CNB’s long-term target of 2 percent. Expectations of higher inflation in the short run would result in lower real interest rates, thereby creating a virtuous cycle of rising consumption, investment, and underlying inflation. These would help steer the economy away from the risk of a bad deflation and recession scenario, which was the main fear of the CNB.
How successful has this policy proven? While, in Laxton’s words, it is “too soon to declare victory”, monthly indicators of economic activity (e.g., exports and retail sales) have rebounded, and inflation expectations for 2015 have risen a full 40 basis points. With a little luck, the Czech economy appears to be heading toward a strong recovery.
However, assuming that foreign exchange interventions prove an effective tool, how relevant is the experience of the CNB for other central banks? The short answer: quite relevant, but with important caveats.
Notably, several characteristics of the Czech economy, as Laxton explained, differentiate it on important fronts from some other economies — particularly major economies.
For one, the Czech Republic is a very small economy, meaning that it is unlikely to come under external criticism for engaging in beggar-thy-neighbour polices.
Second, the Czech economy is also highly open. With imported goods representing approximately one third of the CPI basket, there are fairly strong and direct effects of the depreciation on the CPI. Higher expected inflation would imply lower real interest rates and hence stronger domestic demand. Given nominal rigidities (wages), the nominal depreciation would result in a real depreciation in the exchange rate that should provide significant stimulus to real exports (high share of GDP) and aggregate demand.
With these caveats in mind, there are important lessons that can be (tentatively) drawn from the Czech experience. The first lesson, as Laxton highlighted, is that the CNB fully incorporated the exchange rate tool into an existing Inflation-Forecast Targeting framework. In particular, the central bank made it clear that it was not introducing the exchange rate as a new objective of monetary policy. Rather, as with the policy rate, it was selecting the exchange rate as a tool to achieve its output and inflation objectives. The CNB stressed that if the initial 5 percent depreciation was not enough to achieve its objectives, it stood ready to provide additional stimulus using the exchange rate tool, as it would in normal times when it adjusts its policy interest rate.
The second lesson is that policy commitments, unsurprisingly, need to be credible. The use of the exchange rate tool was credible because it was consistent with both the short-run and long-run objectives of the CNB. In the short run, a depreciated exchange rate will help boost economic activity, and in the long run, it will increase the price level. In fact, CNB’s commitment to its output-inflation objectives proved so credible that it actually only had to engage in foreign exchange interventions for a few days.
Finally, the CNB devised a communication strategy to support this new policy tool, highlighting why it was being used and under what conditions it would exit from the policy.