The current monetary conditions in the Czech Republic: tight or easy?
When assessing how monetary policy affects the economy, some economic commentators have a tendency to look almost exclusively at the current level of nominal monetary policy rates or compare it to the current annual inflation – the percentage change in prices over the past 12 months. In a recent blog article, we pointed out the importance of ex ante real monetary policy rates, where current monetary policy rates are adjusted for expected inflation, not past inflation. Ex ante real interest rates thus better capture the effect of the current levels of interest rates which businesses and households compare with their future expectations.
However, commentaries on monetary policy often forget its other integral part, together with which it creates monetary conditions,[1] and that is the exchange rate. The almost exclusive focus on the current level of monetary policy rates is likely a reflection of the fact that economists study mainly from textbooks and other sources written by authors from US universities. These are based on analyses of the US economy where interest rates are really the key variable. However, in small open economies, including the Czech economy, the exchange rate is another major factor through which monetary policy affects the economy. The question of whether the exchange rate is too strong or too weak is not a simple one, and answering it requires, among other things, estimating a certain fundamental, equilibrium, natural or neutral exchange rate level. If the exchange rate is fluctuating above this level, it is relatively weak, having an expansionary (including increasing the competitiveness of exporters) and potentially inflationary effect on the economy. Conversely, if it is relatively strong, it dampens domestic economic activity and can have anti-inflationary effects.
And because economists are fond of aggregate indices, which capture the whole story of the economy, the real monetary conditions index (RMCI) has been used for small open economies for several decades now.[2] This combines the effect of both the interest rate component and the exchange rate component and shows how tight or easy the overall monetary policy stance is.
Chart 1 – Real monetary conditions in the Czech Republic: the effect of interest rates and the exchange rate
Note: Positive values indicate an expansionary effect and negative values a restrictive effect of the given component of monetary conditions. The interest rate component is based on the 3M PRIBOR, which is deflated by the inflation expectations of financial market analysts at the one-year horizon. The exchange rate component is expressed as the deviation of the real effective exchange rate from the average of the BEER and FEER equilibrium estimates.
The monetary conditions index was already part of the former CNB core prediction model (QPM) at the start of the century, but the current version of the index was presented by the CNB in 2015.[3] In the interest rate part, it uses the ex ante real short-term interest rate adjusted for the inflation expectations of financial market analysts at the one-year horizon, more precisely its deviation from the long-term average. In the exchange rate part, the index is based on the deviation of the real effective exchange rate from the equilibrium levels which are estimated using the FEER and BEER model methods.[4] The average of these two methods is used as a reference value. The interest rate component and the exchange rate component are then combined at the ratio of 3:1, which is based on their estimated relative effect on the economy. It's worth mentioning that the same ratio is used by the Bank of England[5] and the Bank of Canada.[6]
So how is the CNB's monetary policy working overall now, aided by both the interest rate and exchange rate components? Chart 1 shows that monetary policy has recently been having a considerably restrictive effect (i.e. the index is negative). By historical comparison, the overall monetary conditions were tighter only between summer 2007 and summer 2008 when, in addition to elevated interest rates, the koruna appreciated strongly. However, a similar situation is also evident today. Real interest rates adjusted for expected inflation are markedly positive. The exchange rate is stronger than the equilibrium estimates. Chart 2 shows that real monetary conditions are considerably restrictive in the Czech Republic. By contrast, they remain easy in the euro area according to the European Commission's comparable indicator.[7]
Chart 2 – Real monetary conditions in the Czech Republic and the euro area
Note: Positive values indicate an expansionary effect and negative values a restrictive effect of monetary conditions. This is consistent with the RMCI for the euro area (European Commission) multiplied by -1. Using a factor model, the alternative RMCI index for the Czech Republic combines the effects of monetary policy through client market rates on the individual sectors of the economy. Its absolute level is a dimensionless variable; the scale is chosen according to the other series in the chart. Zero indicates the long-term average.
Interestingly, central banks in major economies have shifted their focus to more broadly defined indices of financial conditions in recent years. Besides the fact that the exchange rate plays a relatively smaller role in major economies than in small open economies such as the Czech Republic, the decline in interest in monetary conditions indices was probably also related to the long-lasting zero interest rate policy and the use of unconventional monetary policy instruments. In that context, it became important to monitor a wider range of indicators capturing market and credit risk, interest rate spreads and the evolution of asset prices. One of these indices is compiled by the Federal Reserve Bank of Chicago.[8] Another closely monitored one is the Goldman Sachs index.[9] Another index used by the CNB which we call the "alternative RMCI" for the Czech Republic is inspired by the idea of these broader financial conditions indices. Using a factor model, this index combines the effects of monetary and financial conditions via market rates on the end sectors – households, non-financial corporations, banks and the government. This index stays close to the long-term average level and in no way indicates an expansionary setting of monetary and financial conditions.
To sum up, real monetary conditions in the Czech Republic are not currently expansionary, neither by historical comparison, nor relative to the euro area. The two main components of monetary conditions, as estimated by the CNB, are affecting the economy and inflation in a way which is dampening demand and hence also inflation pressures. It cannot be ruled out that the restrictiveness of monetary policy may not be sufficient in the coming months. Accelerating growth in wages, a too slow fading of core inflation and rapidly recovering credit growth accompanied by rising share prices could be such signals. Therefore, even at this time when inflation pressures seem to be easing, a need for a further tightening of monetary policy cannot be fully ruled out. However, it is important to bear in mind that this tightening can take place through both interest rate and exchange rate conditions.
[1] https://www.cnb.cz/en/faq/What-are-the-monetary-conditions/
[2] https://www.rbnz.govt.nz/-/media/07e2dc6194ef42d69046ce237f3ecc09.ashx?sc_lang=en
[3] https://www.cnb.cz/en/monetary-policy/inflation-reports/boxes-and-annexes-contained-in-inflation-reports/The-monetary-conditions-index-for-the-Czech-Republic
[4] https://www.cnb.cz/en/about_cnb/cnblog/The-koruna-is-in-sight-of-its-fundamental-equilibrium-exchange-rate/
[5] https://core.ac.uk/download/pdf/6377749.pdf
[6] https://www.bis.org/publ/confp06i.pdf
[7] https://economy-finance.ec.europa.eu/economic-research-and-databases/economic-databases/monetary-conditions-index_en
[8] https://www.chicagofed.org/research/data/nfci/current-data
[9] https://www.goldmansachs.com/insights/pages/case-for-financial-conditions-index.html