Are interest rates really unusually low by comparison to inflation?

In recent months, there has been lively debate in the public domain on whether the CNB’s monetary policy rates are too low given inflation and inflation expectations. Some participants in the debate have referred to real rates, i.e. nominal rates adjusted for inflation. This is perfectly okay, as the concept of real interest rates is a good guide as to how tight or easy monetary policy works in the economy. However, calculating real interest rates can be approached in different ways, especially when it comes to the inflation rate (actual or expected, derived from the consumer price index or another price index) and the type of interest rate.

Chart 1 – Interest rates and inflation

Note: inflation in year-on-year terms. Data sources: CNB and CZSO.

Ex-post real interest rates

Commentaries on monetary policy are often based on a simple comparison of the monetary policy rates and headline inflation derived from the consumer price index or from the narrower measure of core inflation. Chart 1 presents the evolution of these indicators over the last 25 years. Chart 2 shows the “ex-post” real interest rate calculated from these indicators. The ex-post real monetary policy rate derived from headline inflation was generally positive in the Czech Republic until 2007 and right up until 2014 when core inflation was used. It was then almost permanently negative. This was not a specifically Czech phenomenon. A similar trend can be observed for most advanced economies, including the euro area.

Chart 2 – Ex-post real interest rates

Note: year-on-year inflation for the given month, i.e. price growth in the past 12 months, is deducted from the 2W repo rate.

Ex ante real interest rates

Economists agree that ex ante real interest rates are a more suitable concept. In this case, interest rates are adjusted for inflation which is still expected, not inflation that has already occurred. Inflation derived from the data published by the Czech Statistical Office is a thing of the past. It no longer has any major bearing on today’s decisions by individuals and companies on whether to save more or spend more, nor does it affect decisions on whether to create buffers or engage in the debt-financing of investments. These decisions are affected by the interest rates which reflect expectations, outlooks and forecasts of inflation in the future. Or to be more precise, in a future which corresponds to the maturity of the relevant interest rate.

Savers wonder whether the interest they are offered will cover at least expected inflation. Companies weigh up whether investments made today at the rate they are offered will pay off in a year’s time when they sell at the expected price. This is why inflation forecasts and inflation expectations play such an important role in monetary policy decision-making. Past inflation does not play such a major role and it doesn’t make much sense to deduct it from the interest rates that are applicable from now to the future.

Chart 3 – Ex ante real monetary policy rates

Note: year-on-year inflation expected one year ahead, i.e. price growth over the next 12 months, is deducted from the 2W repo rate.

What current real interest rates tell us about monetary policy decision-making

When calculating ex ante real interest rates, several measures of expected inflation can be used. This is why the results may differ widely (see Chart 3). It is natural for us to start with our own inflation forecast published by the CNB. The forecast expects inflation of 2.3% twelve months from now. According to CNB experts, there won’t be much additional inflation from February of this year. Almost all the inflation already occurred at the start of the year. This mainly includes energy price increases to the price caps set by the government, but also other January price list adjustments affecting other parts of the consumer basket. From this perspective, ex ante real interest rates are already strongly positive, reaching 4.7%. In other words, monetary policy rates now exceed the rate of expected price growth in the near future.

Ex ante real interest rates expressed on the basis of the inflation expectations of financial market analysts provide a similar view.^[1] This is a group of experts who are independent of the CNB and are paid for the accuracy of their forecasts. They expect inflation of 4.8% at the one-year horizon. That exceeds the rate expected by CNB experts, but not dramatically so. Given the current monetary policy rates, this means that real rates (expressed in these terms) have moved above 2%, the most since the start of this particular survey by analysts.

The inflation expectations of non-financial corporations are somewhat more complicated. These expectations are collected quarterly and, at the end of 2022, still exceeded 10% at the one-year horizon. Real interest rates thus remained quite negative. However, if this 10% included the expected January repricing of 6% (month on month), then not much of it is left for the rest of the year – which is comparable to the analysts’ January outlook. However, we will have to wait until March for the results of the new non-financial corporations’ survey.

How do the CNB’s real interest rates fare by international comparison?

But why just stay with the Czech Republic? The setting of monetary policy rates from an ex-ante real perspective can be assessed in the international context. The OECD regularly publishes a mutually consistent inflation forecast for a wider sample of countries, the latest of which is from November 2022. It contains an inflation forecast one year ahead – i.e. for the start of 2024 – which is important for us.

So, how do the CNB’s ex ante real interest rates compare to those of other OECD countries? This will perhaps come as a surprise to some, but they are almost at the top. Given the inflation rate expected at the one-year horizon, positive real interest rates are not at all common by international comparison, with rates in most countries still in negative territory. In terms of this notional measurement of monetary policy tightness, the Czech Republic is right after Hungary and the USA. The euro area as a whole, or the European Central Bank, despite its declared determination to fight inflation, is only in the second half of the ranking. Some euro area Member States (the Baltic states and Slovakia) lag way behind due to high expected inflation and still relatively low ECB rates.

Chart 4 – International comparison of ex ante real interest rates

Note: The OECD annual inflation forecast for the given country for the start of 2024 – i.e. the expected growth of prices in the given economy in the next 12 months – is deducted from the key monetary policy rates in the relevant country in February 2023.

Do we need even tighter monetary conditions?

From a historical perspective, ex ante real interest rates are not currently at unusually low levels. An ex-post perspective comparing today’s interest rates (valid for the future) with past inflation is misleading, as it mixes different periods together.

It is possible of course that current inflation expectations fail to materialise. However, in a small economy like the Czech Republic, inflation in the future may turn out not only to be higher than we previously thought, but it may also turn out to be significantly lower. Therefore, when assessing the tightness of monetary conditions, it is also important we look at the exchange rate. Given that the koruna has mostly appreciated against the euro in recent months (despite the ECB raising interest rates), we consider the overall monetary conditions as quite restrictive. On the other hand, the labour market remains relatively tight, and this represents a significant inflationary risk. In this situation, the decision on whether to tighten monetary policy further must – metaphorically speaking – be carefully weighed up on an apothecary’s scales.

^[1] https://www.cnb.cz/en/financial-markets/inflation-expectations-ft/