Three Deflations in the Czech(-oslovak) History: Two that did happen, and one that did not

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1 Three Deflations in the Czech(-oslovak) History: Two that did happen, and one that did not Vladimír Tomšík Vice-Governor Czech National Bank EABH Conference: History of Inflation Prague, 15 May 15

2 Outline CNB s policy decision in November 13 Why was the policy action needed? Our historical experience with two deflation episodes Outcomes so far the story of averted deflation Conclusions

3 Outline CNB s policy decision in November 13 Why was the policy action needed? Our historical experience with two deflation episodes Outcomes so far the story of averted deflation Conclusions 3

4 CNB s November 13 decision The Board decided to start using the exchange rate as an additional instrument for easing the monetary conditions, stating that: The CNB will intervene on the FX market to weaken the koruna so that the exchange rate is close to CZK 7/EUR. The exchange rate level was chosen to avoid deflation or long-term undershooting of the inflation target and to speed up the return to the situation in which the CNB will be able to use its standard instrument, i.e. interest rates. The exchange rate commitment is one-sided. This means that the CNB stands ready to prevent excessive appreciation of the koruna exchange rate below CZK 7/EUR. On the weaker side of the CZK 7/EUR level, the CNB is allowing the exchange rate to move according to supply and demand on the FX market. 4

5 The exchange rate since the decision CZK/EUR rate and CNB commitment CNB s forex transactions 8, 7, mil EUR 7499 mil. EUR 7, 1 6,5 8 6, 5,5 5, mil. EUR 6 4 4,5 4, 3,5 1/1 7/1 1/13 7/13 1/14 7/14 1/15 CZK/EUR 7 CZK/EUR level - 1/98 1/ 1/ 1/4 1/6 1/8 1/1 1/1 1/14 intervention sale of FX reserves yields buy-up from Privatisation Account to FX reserves The exchange rate weakened immediately and has moved with relatively low volatility above the level of CNB s commitment. Actual interventions were quite massive, but took place only for a few days after the policy decision of the CNB. 5

6 Outline CNB s policy decision in November 13 Why was the policy action needed? Our historical experience with two deflation episodes Outcomes so far the story of averted deflation Conclusions 6

7 Main policy interest rates 6% 5% Lombard rate W repo rate Discount rate 4% 3% % 1% % In November 1, the CNB hit the zero lower bound (ZLB). Since then, the policy rates have been set at technically zero level:.5 % for the W repo rate and O/N deposit (i.e. discount) rate, and.5% for the O/N lending (i.e. Lombard) rate 7

8 The need for MP easing in November M PRIBOR (in %) IV/11 I/1 II III IV I/13 II III IV I/14 II III IV I/15 II 9% 7% 5% 3% confidence interval Consistent with the forecast in November 13 was a significant decline in market interest rates well below zero, which would have required 4 further policy rate cuts. 8

9 Inflation actual vs. targets 8% (y/y, in %) 6% 4% % % -% Headline inflation MP-relevant inflation Headline inflation was close to 1 % in 13 (i.e. well below the target, but seemingly far from deflation) only due to indirect tax increases. MP-relevant inflation had been below the target from November 1, and it was falling toward zero during 13. 9

10 Structure of inflation (y/y, in %, contributions in p.p.) Core inflation (y/y, in %) / / / Adjusted inflation excluding fuels and food Administered prices Indirect taxes in non-administered prices Food prices (including alcoholic beverages and tobacco) Fuel prices Annual consumer price inflation (in per cent) -6 1/1 1/11 1/1 1/13 1/14 1/15 Adjusted inflation (except fuels) Prices of non-tradables (except administered prices) Prices of other tradables (except food and fuels) In 13, administered prices and tax changes were contributing significantly to inflation, but it was clear that this would fade away in 14. Even more importantly, core inflation had been negative from 9, and within its structure, prices of non-tradables stopped growing for the first time in modern Czech history in mid-13. 1

11 Economic activity GDP growth (y/y, in %) Contributions to GDP growth (in p.p.) I/1 I/11 I/1 I/13 I/14-1 I/8 I/9 I/1 I/11 I/1 I/13 I/14 Czech Republic Germany Austria Hungary Poland Slovakia Household consumption Gross fixed capital formation Change in inventories Net exports Government consumption NPISH expenditure The Czech economy was going through the longest recession in its independent history, significantly under-performing its regional peers. Fiscal restriction in 1-13 played a very significant role. The decline was mainly due to falling consumption and investment. 11

12 Output gap (in % of potential output) I/6 I/7 I/8 I/9 I/1 I/11 I/1 I/13 I/14 I/15 I/16 HP filter Kalman filter Production function The output gap was estimated at - to -4 %, i.e. according to some methods even deeper than in previous post-lehman recession. 1

13 Passive MP scenarios November 13 4 Headline inflation (y/y in %) 7 CZK/EUR I/1 III I/13 III I/14 III I/15 III 4 I/1 III I/13 III I/14 III I/15 III 1,4 1, 1,,8,6,4,, -, -,4 -,6 3M PRIBOR (in %) I/1 III I/13 III I/14 III I/15 III GDP (y/y in %) Baseline scenario Passive MP Passive MP +ER shock I/1 III I/13 III I/14 III I/15 III The CNB analyses clearly showed that a passive monetary policy would have been associated with negative inflation, nominal exchange rate appreciation and weak economic recovery. The CNB perceived a risk of the short-term negative inflation turning into protracted deflation. 13

14 All scenarios compared 4 Headline inflation (y/y in %) 4 MP-relevant inflation (y/y in %) I/1 III I/13 III I/14 III I/15 III -1 I/1 III I/13 III I/14 III I/15 III 1,4 1, 1,,8,6,4,, -, -,4 -,6 3M PRIBOR (in %) I/1 III I/13 III I/14 III I/15 III GDP (y/y in %) Baseline scenario Passive MP Passive MP +ER shock Alternative scenario I/1 III I/13 III I/14 III I/15 III The use of exchange rate as a further MP instrument with a floor at 7 CZK/EUR was described by the alternative scenario, in which the risk of deflation would be averted, inflation would return to the target relatively fast and the economic growth would speed up notably. 14

15 Outline CNB s policy decision in November 13 Why was the policy action needed? Our historical experience with two deflation episodes Outcomes so far the story of averted deflation Conclusions 15

16 Rašín s deflationary policy in The deflationary policy in the post-wwi period helped to establish the culture of price stability in Czechoslovakia, but at a high cost (both economically, and for Alois Rašín himself). Inflation and Price Level GDP inflation (y-o-y, left-hand scale) price level (1913=1, right-hand scale) 1 9 Note: from 1913 to 19 unweighted index of adminstrated prices of 38 items, between prices of food, fuels, petrol and soap, from 194 food prices. Source: Ministry of Finance Report on Supplying People in Czechoslovakia, 19, Statistical Handbook of Czechoslovakia, 195, Price Reports of Statistical Office , Matoušková (8) in CZK bil. (left-hand scale) 1913=1 (right-hand scale) 16 8

17 The Great Depression policy debate There was a similar policy debate to the current one in Czechoslovakia 8 years ago. Vilém Pospíšil (proponent of Gold Standard, follower of Alois Rašín) versus Karel Engliš (proponent of price stability, closer to the modern view) Pospíšil Engliš 198= wholesale prices retail prices February 1934: Pospíšil steps down as the Governor of NBČS, is succeeded by Engliš and koruna is devalued by 1/6. As a result, the five years of economic recession and deflation in Czechoslovakia end (later than in many other countries that have eased their MP sooner). 17

18 Outline CNB s policy decision in November 13 Why was the policy action needed? Our historical experience with two deflation episodes Outcomes so far the story of averted deflation Conclusions 18

19 Overall monetary conditions,3,,1, -,1 -, -,3 -,4 I/4 I/5 I/6 I/7 I/8 I/9 I/1 I/11 I/1 I/13 I/14 I/15 Exchange rate component Interest rate component Basic RMCI The CNB s policy measure has significantly eased the overall monetary conditions, both in their interest rate (via higher inflation expectations) and exchange rate components. 19

20 Comparison of the data available then and now y/y in % Data available on 7 Nov 13 Data available now GDP (s.a.) II/ IV/ Household consumption (s.a.) II/13. IV/14. Gross fixed capital formation (s.o.) II/13-5. IV/ CPI 9/ /15.3 Unemployment rate (ILO definition, s.a.) 9/ / Average nominal wage II/13 1. IV/14.3 Average nominal wage in business sector II/ IV/ Number of vacancies (s.a.) 9/ / Overall confidence indicator (index) 1/ / Retail sales without automobile segment (s.a.) 9/ / Key indicators of the real economy look much better now than in November 13. GDP is growing, which is having a favourable impact in the labour market and on the confidence of households and enterprises. Inflation remains very low, but this mainly reflects the foreign environment. The data thus show that the weaker exchange rate has fulfilled its purpose, averting the risk of deflation driven by insufficient demand.

21 Factors of improved GDP dynamics Difference GDP -.7%.%.7 p.p. Gross value added -.6%.6% 3. p.p. Contributions of individual factor to the GDP (GVA) dynamics Fiscal policy -.95 p.p..4 p.p. 1. p.p. EA growth.4 p.p. 1. p.p..6 p.p. Monetary policy (+ sentiment).9 p.p. (1.4 p.p.) Source: CNB, CZSO The GDP dynamics improved by.7 p.p. in 14 compared to 13 (GVA, which is less affected by one-off effects of tax changes, improved its dynamics by 3. p.p.). EA developments and fiscal policy explain 1.8 p.p. altogether. The remaining.9 p.p. (1.4 p.p. for the GVA) are attributable to the relaxation of monetary policy (+ improved sentiment). The weaker koruna thus contributed to the economic recovery significantly. 1

22 Core inflation measures 5 (y/y in %) /4 1/6 1/8 1/1 1/1 1/14 Median inflation Adjusted inflation w/o fuels Net inflation Low inflation is given primarily by falling fuel and food prices. Core inflation measures have increased since November 13, and are now at 1 % (including the median inflation, which reached its historical low in late-13, when it was at the edge of deflation).

23 Inflation forecast 6 (y/y in %) 5 4 Monetary policy horizon 3 Inflation target I/1 I/11 I/1 I/13 I/14 I/15 I/16 Monetary policy-relevant inflation Headline inflation Once the current anti-inflationary supply-side shocks fade away, inflation will start increasing toward the CNB s % target. This will be fostered by a continued growth of the domestic GDP and accelerating nominal wage growth in the business sector. It is important to make sure that inflation expectations remain well anchored. 3

24 Outline CNB s policy decision in November 13 Why was the policy action needed? Our historical experience with two deflation episodes Outcomes so far the story of averted deflation Conclusions 4

25 Conclusions On November 13, the CNB took a decisive action to avert the risk of deflation driven by insufficient aggregate demand. Two episodes from Czechoslovak inter-war history clearly show that a deflation is not to be regarded as price stability, and it may have significant welfare costs. The CNB s exchange rate commitment has significantly contributed to the economic recovery and improved labour market situation. But once the direct effects of low oil prices fade away, inflation will start returning to the CNB s % target. The CNB s role is to make sure that inflation expectations remain well anchored. 5

26 Thank you for your attention Vladimír Tomšík 6