Monetary Policy of CNB:

43rd Eurobanking Meeting Prague 15 Monetary Policy of CNB: Czech FX Commitment Midterm Assessment Lubomír Lízal, Ph.D. Praha, June 1, 15

Situation of the Czech economy in 13: Inflation actual vs. targets (y/y; %) Inflation was decreasing and was at the lower boundary of the tolerance band around the CNB s target (below 1%) at the end of 13. In spite of VAT and other tax increases. MP inflation was around zero and also showed a decreasing tendency.

Situation of the Czech economy in 13: Core inflation tradables and non-tradables (y/y; %) 15 1 Adjusted inflation (except fuels) Prices of non-tradables (except administered prices) Korigovaná inflace bez pohonných hmot (PH) Neobchodovatelné-ostatní Obchodovatelné-ostatní Prices of other tradables bez (except PH food and fuels) 5-5 -1 1/94 1/97 1/ 1/3 1/6 1/9 1/1 Core inflation negative since 9. For the first time in modern history the growth of prices of nontradable goods (and services) stopped. This is very unusual, especially for a converging economy. Partly, this was caused by a decline in prices of communication services. But primarily, it reflected weak demand and slow wage growth. 3

Situation of the Czech economy in 13: Structure of GDP growth (y/y; p.p.) 6 4 - -4-6 -8 I/9 I/1 I/11 I/1 I/13 Household consumption Gross fixed capital formation Change in inventories Net exports Government consumption NPISH expenditure Czech economy back in recession since the beginning of 1. Net exports had a positive contribution only in Q13. Fixed investments were negative, change in inventories fluctuated. The drop in consumption has stopped. 4

Situation in November 13 Inflation Report IV/13: Interest rate forecast Consistent with the forecast was a significant decline in market interest rates well below zero. (3M PRIBOR in %) 4 3 1-1 - 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 was a significant decline in market interest rates well below zero, followed by a rise in rates above the current levels only at the end of 14. But W repo rate lowered to.5% on November 1, 1! Given the zero lower bound (ZLB) on interest rates, this pointed to a significant need to ease monetary policy using other instruments. 5

The Bank Board s decision of November 13 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 will 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. 6

Interest rate and exchange rate 4 38 36 34 3 3 8 6 4 Development of W REPO rate (in %) and CZK/EUR exchange rate CZK/EUR W Repo (right axis) 1 9 8 7 6 5 4 3 1 1999 1 3 4 5 6 7 8 9 1 11 1 13 14 Monetary policy easing & exchange rate depreciation go hand in hand. Impossible trinity: cannot have independent monetary policy, stable exchange rate, and free movement of capital at the same time! 7

CZK/EUR rate and the CNB commitment 8.5 8. 7.5 7. 6.5 6. 5.5 5. 4.5 4. 3.5 1/1 1/11 1/1 1/13 1/14 1/15 CZK/EUR 7 CZK/EUR level After the CNB s policy announcement, koruna reached 7 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. 8

CNB s FX operations and the exchange rate Actual interventions were quite massive, but took place only for a few days after the policy decision of the CNB. 9

Real effective exchange rate (7=1%) 14 13 1 Czech koruna Swiss franc 7 average = 1 11 1 9 8 7 US liquidity crisis Swiss FX commitment Czech FX commitment 6 Fall of Lehman Brothers 5 1/95 1/97 1/99 1/1 1/3 1/5 1/7 1/9 1/11 1/13 1/15 Source: BIS SNB trying to tame the strong appreciation of Swiss franc after the 8 crisis. Real effective exchange rate of CZK appreciated by 1% during the crisis period, which is equivalent to permanent tightening of monetary policy. Counteracted by interest rate decreases. Verbal interventions only have limited effects and work only for limited time. Still, different reason for intervention regime than in the Czech Republic. 1

Monetary conditions in the Czech Republic Source: CNB IR II/15 Basic RMCI version (positive values refer to easy monetary conditions and negative values to tight monetary conditions; source: CNB, CNB calculation) 33 3 31 3 9 8 7 6 5 4 -,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 GDP decrease Interest rate component Basic RMCI Real monetary conditions index = 3M PRIBOR market rate adjusted for inflation expectations + exchange rate component. Describes the aggregate monetary policy stance. The monetary conditions have been very accommodative since the end of 13, albeit rather less so recently as a result of a fall in inflation expectations.,3,,1, -,1 -, -,3 Exchange rate component CZK/EUR 11

Nominal interest rates in the Czech economy Interest rates in the Czech economy (percentages) 4 3 1 1/1 1/11 1/1 1/13 1/14 1/15 W repo rate 3M PRIBOR Interest rate on loans to non-financial corporations 3M PRIBOR rate (.3%) remains at historical lows and reflects the setting of the CNB s key interest rates at technical zero. Interest rate on loans to non-financial corporations decreased slightly in nominal terms in 15 Q1, remaining close to % for koruna loans. 1

Monetary conditions: What influences investment return? Investment decision-making: Profitability of a project described by the net present value. NPV takes into account future cash flows and discounts them using opportunity interest rate, i.e. the expected yield of projects of the same riskiness. Expected real interest rate has the following components: 1. Expected nominal interest rate. Expected inflation rate (with the minus sign) How to influence the (expected) interest? By cutting the (nominal) interest rates. Easy, if interest rates positive and non-zero. If already at the zero lower bound, it is possible to announce interest rate commitment and pledge that the rates will stay at a given low level for a given time period (e.g. forward guidance by Fed). 13

How to deliver monetary easing? Alternative tools: How to influence the expected inflation? 1. Inflation targeting policy In standard times, nominal interest rates are able to influence expected inflation. Problems arise at the zero lower bound.. Un-conventional tools such as quantitative easing By changing the structure of financial assets in the economy, central banks are able to influence long-term interest rates and indirectly also expected inflation in the future (Fed, BoE, ECB). 3. Direct weakening of currency The exchange rate component can be used at any time, central bank can intervene against its own currency without limits. Possible to announce FX commitment pledge to not allow the strengthening of the currency above a give level for a given time period (CNB). The CNB s FX commitment increases inflation expectations, decreases real interest rates, delivers easing of monetary conditions, and therefore encourages consumption of durable goods and increases investment activity. 14

Trade balance surplus and investment (CZK bn.) 5 4 3 1-1 5 6 7 8 9 1 11 1 13 14 65 75 85 95 15 115 15 cross-border concept national concept investment (right axis; inverted) About 6-8% of investment is imported. Yearly nominal investments between 8 and 13 decreased by 17 bn. CZK. Net exports therefore had to improve by about 1-135 bn. CZK (= 17*.6-17*.85) solely as a statistical consequence. Total trade balance surplus in 13 was 17 bn. CZK. Perceived good results of foreign trade caused appreciation pressures. Already in 1H 14, trade balance surplus +7 bn. CZK and investment +3 bn. CZK compared to 1H 13 -> pattern broken! 15

Household savings and investment Household saving rate The saving rate will fluctuate just above 1% over the entire forecast horizon (percentages) 14 Gross capital formation Gross capital formation will rise, boosted this year by the drawdown of EU funds (annual percentage changes; seasonally adjusted) 15 13 1 1 5 11 1-5 9 I/1 I/11 I/1 I/13 I/14 I/15 I/16 Saving rate (seasonally adjusted) The saving rate constantly decreased over time from 1.5% in 1, to nearly stable 11.5% in 11-1, and to 1.5% in 13 and 14. The same value is expected this year, too. Investments growth since the announcement of FX commitment, will continue in 15. -1 I/1 I/11 I/1 I/13 I/14 I/15 I/16 Gross capital formation Gross fixed capital formation 16

Development since November 13 Annual percentage changes Available on 7.11.13 Available on 15.5.15 Gross domestic product (s.a.) II/13-1.3 I/15 3.9 Consumer price index 9/13 1. 4/15.5 General unemployment rate (in %, s.a.) 9/13 7.1 3/15 5.9 Average nominal wage II/13 1. IV/14.3 Number of vacancies 9/13 39,4 4/15 83,7 Gross operating surplus of nonfinancial corporations II/13 1.3 14 13.3 Insufficient demand as a limit of production in industry (in %) IV/13 5. 4/15 44. Composite confidence indicator (index) 1/13 88.9 4/15 95.1 Almost all key macroeconomic indicators visibly changed in positive direction i.e. in accordance with the CNB s predictions. Inflation is lower compared to November 13, but monetary policy-relevant inflation (without primary impact of indirect taxes changes) was.5% in April 15, which is higher than on the beginning of 14. 17

GDP growth decomposition 1,1 Monetary policy + sentiment (+1 pp.) Fiscal impuls (+1. pp.) Foreign demand (+.5 pp.), Growth in 14 (+.%) -,7 Growth in 13 (-.7%) The Czech Republic among the 1 worst-performing countries of the EU up to 13: GDP -1.3% in Q 13. In 14: GDP +%, and the Czech Republic moved among the top 1 EU members. The change in dynamics of the Czech GDP reached.7 pp. in 14 (from -.7% in 13 to.% in 14). Foreign demand + fiscal impulse explain 1.7 pp., the remaining 1 pp. can be attributed to the monetary policy action combined with improved sentiment of businesses and households. 18

Forecasts of inflation, interest rates, and GDP: Then (IR IV/13) and now (IR II/15) Headline inflation forecast Headline inflation will be close to zero in 15 and rise to the target next year (year on year in %) Monetary policy-relevant inflation forecast Monetary policy-relevant inflation will fluctuate around zero this year and then start to rise, converging to the target at the end of the monetary policy horizon (year on year in %) 6 5 4 3 9% 7% 5% 3% confidence interval IR IV/13 Inflation target Monetary policy horizon 6 5 4 3 Inflation target Monetary policy horizon 1 1-1 -1 - II/13 III IV I/14 II III IV I/15 II III IV I/16 II III IV - II/13 III IV I/14 II III IV I/15 II III IV I/16 II III IV 9% 7% 5% 3% confidence interval Interest rate forecast The forecast expects market interest rates to be flat at their current very low level until the end of 16, i.e. over the entire forecast horizon (3M PRIBOR in %) GDP growth forecast GDP growth will gradually accelerate (annual percentage changes; seasonally adjusted) 3 1 8 6 4 9% 7% 5% 3% confidence interval IR IV/13 1 - II/13 III IV I/14 II III IV I/15 II III IV I/16 II III IV -4 II/13 III IV I/14 II III IV I/15 II III IV I/16 II III IV 9% 7% 5% 3% confidence interval Does it mean that the exchange rate tool doesn t influence prices? 19

February 15 sensitivity scenario: No intervention regime 3.5 3.5 1.5 1.5 Czech GDP (y/y in %) I/14 II/14 III/14 IV/14 Actual GDP Nov 13 CNB forecast Hypothetical GDP had the koruna not been weakened Note: Actual GDP and hypothetical GDP for 14 Q4 are based on the CZSO s flash estimate of GDP. These figures may be subject to revision. Had the monetary conditions not been eased in November 13 using the exchange rate, the economy would have grown by around.5% in 14...

February 15 sensitivity scenario: No intervention regime.5 1.5 1.5 -.5-1 -1.5 - -.5 Czech inflation (y/y in %) I/14 II/14 III/14 IV/14 Actual inflation Nov 13 CNB forecast Hypothetical inflation had the koruna not been weakened and inflation would now be running at about -%. 1

February 15 sensitivity scenario: No intervention regime.5 1.5 1.5 -.5-1 -1.5 - Czech household consumption (y/y in %) I/14 II/14 III/14 IV/14 Actual household consumption Nov 13 CNB forecast Hypothetical consumption had the koruna not been weakened The actual impact on domestic household consumption near the predicted levels reveals that the weakening of koruna was successful in helping domestic demand.

Euro area consensus forecast in November 13 and February 15 (differences in p.p.) Effective GDP in the euro area (annual % change) (differences in p.p.) Effective CPI in the euro area (y-o-y in %).1 3.1. -.1 -.3 -.5 -.7 -.9-1.1 Differences CF February 15 CF October 13 I/13 II III IV I/14 II III IV I/15 II III IV I/16 II III IV 1-1 -. -.5 -.8-1.1-1.4-1.7 -. I/13 II III IV I/14 II III IV I/15 II III IV I/16 II III IV 1.5 1..5. (differences in p.p.) Effective PPI in the euro area (y-o-y in %) (differences in p.p.) 3M EURIBOR (in %).5 -.5-1.5 -.5-3.5 3 1-1.1 -.1 -.3 -.5 -.7 -.9-1.1-1.3 1.6 1.4 1. 1..8.6.4. -4.5 I/13 II III IV I/14 II III IV I/15 II III IV I/16 II III IV - -1.5 I/13 II III IV I/14 II III IV I/15 II III IV I/16 II III IV. (differences in %) EUR/USD exchange rate (USD/EUR) (differences in %) Price of Brent crude oil (USD/barrel) 6 1.4 1 115 1.35 15 - -6 1.3 1.5 1. -1 - -3 95 85 75-1 1.15-4 65-14 I/13 II III IV I/14 II III IV I/15 II III IV I/16 II III IV 1.1-5 I/13 II III IV I/14 II III IV I/15 II III IV I/16 II III IV 55 Strong disinflationary pressures imported from the euro area. 3

Inflation development Structure of inflation (annual percentage changes; contributions in percentage points) Adjusted inflation excluding fuels (annual percentage changes) 3 1-1 1/13 4 7 1 1/14 4 7 1 1/15 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 The very low levels of inflation due to a significant decrease in fuel prices and to a continuing decline in food prices. Core inflation returned to positive figures in 14 after many years of decline. Now growth in both components. Observed development consistent with predicted effects of exchange rate weakening. 1-1 - -3-4 -5 Adjusted inflation (except fuels) Prices of non-tradables (except administered prices) Prices of other tradables (except food and fuels) 4

The latest CNB s monetary policy decision On May 7, the Bank Board decided to continue using the exchange rate as an additional instrument for easing the monetary conditions and confirmed the CNB s commitment to intervene on the foreign exchange market if needed to weaken the koruna so that the exchange rate of the koruna is kept close to CZK 7 to the euro. In line with this, the Czech National Bank still stands ready to intervene automatically, i.e. without the need for an additional decision of the Bank Board, and without any time or volume limits. The asymmetric nature of this exchange rate commitment, i.e. the willingness only to intervene against appreciation of the koruna below the announced level, is unchanged. The subsequent return to conventional monetary policy will not imply appreciation of the exchange rate to the level recorded before the CNB started intervening, as the weaker exchange rate of the koruna is in the meantime passing through to domestic prices and other nominal variables. 5

The latest CNB s monetary policy decision The Bank Board assessed the risks to the new forecast at the monetary policy horizon as being anti-inflationary. Of the three factors which the Bank Board identified at its previous meetings as being crucial in preventing adverse second-round effects of the oil price decrease, domestic wages and the korunaeuro exchange rate have so far been moving in the anti-inflationary direction. By contrast, the optimism about the overall expected benefits of the measures adopted by the European Central Bank for developments in the euro area and in the Czech Republic is growing. In this situation, the Bank Board stated again that the Czech National Bank would not discontinue the use of the exchange rate before the second half of 16. In addition, the Bank Board emphasized again that it was ready to move the level of the exchange rate commitment if needed. 6

Thank you for your attention www.cnb.cz Lubomír Lízal, Ph.D. member of the CNB Board lubomir.lizal@cnb.cz 7

Additional slides 8

Sensitivity scenario: Higher Brent price Low oil price establishes a positive supply shock for the Czech economy in spite of its anti-inflationary impact. How large a shock? Czech Republic is a net importer of oil products. In 1 and 13, when the average price per one barrel of crude oil moved above USD 1, external trade deficit in oil products was between CZK 1 and 13 bn. If oil keeps to be sold for about half per barrel over a longer period, we can expect a similar drop in external trade deficit by approx. CZK 6 bn. (CNB forecast expects the impact of approx. CZK 5 bn.). This translates to about a one-third increase in trade surplus (CZK 17 bn. in 13, CZK 157 bn. in 14). Almost the same stimulus for Czech economy as the whole state budget deficit (CZK 78 bn. in 14). 9

Oil price: Expectations in 13 vs. reality (differences in %) Price of Brent crude oil (USD/barrel) 1-1 - -3-4 -5 Differences CF February 15 CF October 13 I/13 II III IV I/14 II III IV I/15 II III IV I/16 II III IV 115 15 95 85 75 65 55 Oil price expected to be around 1 USD/barrel but dropped to 6 USD/barrel by the beginning of 15 instead. In order to analyze the impact on Czech economy, CNB constructed a sensitivity scenario with oil price fixed at 1 USD/barrel. 3

Sensitivity scenario of the February forecast: Higher Brent price CPI Inflation (y/y, in %) 4 GDP Growth (y/y, in %) 4 4 1 - - I/13 I/14 I/15 I/16 I/13 I/14 I/15 I/16 Household Cons. Growth (y/y, in %) Nominal Wage (y/y, in %) 4 4.8 1.5 1.4.5 - -.4 -.5 I/13 I/14 I/15 I/16 I/13 I/14 I/15 I/16 Oil price - baseline Oil price - 1 USD/bl. With oil price around 1 USD/barrel, inflation would be on average 1 pp. higher in 15, but the GDP and household consumption growth would be significantly lower. 31