MONETARY POLICY REPORT | SPRING 2022 (box 3)
(authors: Tatiana Keseliová, Jan Syrovátka, Tomáš Šestořád, Stanislav Tvrz, Jan Žáček)
The CNB’s price stability mandate involves regularly assessing the fulfilment of the inflation target and determining the causes of any past deviations of actual inflation from the central bank’s target. In the interests of making the CNB’s monetary policy transparent to the public, this analysis has become an annual feature of the Monetary Policy Report.[1] Here, we assess the deviations of inflation from the 2% target in the period 2020 Q2–2022 Q1.
Inflation was above the CNB’s 2% target over the entire period under assessment. It rose well above the target in the second half of last year and early this year (see Chart 1). Chart 2 presents the contributions of the individual factors, which were identified using the g3+ core projection model[2] and are described in more detail in the following paragraphs. This provides an insight into the origin of the inflation pressures faced by the Czech economy in the past.
The monetary policy rule in the g3+ model sets interest rates taking into account the deviation of expected inflation from the 2% target at the monetary policy horizon. The inflation outlook takes on board the forecasts for all relevant macroeconomic variables. The emphasis on the monetary policy horizon reflects the gradual transmission of interest rates to future economic developments and in turn to inflation. By concentrating on inflation at this horizon, the central bank simultaneously abstracts from short-term inflation shocks. Their impact can be controlled by monetary policy to only a minimal extent. In addition, any efforts to mitigate them quickly would cause high interest rate volatility, which would destabilise the economy. The monetary policy rule also includes interest rate smoothing by the central bank. Nonetheless, active monetary policy stabilises inflation at the target in the medium run. This is usually accompanied by gradual movement of interest rates towards their neutral long-run level (3%).
Chart 1 – Inflation was above the upper boundary of the tolerance band around the target for most of the period under review, rising above 10% in early 2022
consumer prices in %
Chart 2 – The significant and increasing overshooting of the target in 2021 and early 2022 was due mainly to an overheating domestic economy and previous too accommodative monetary policy
deviation of monetary policy-relevant inflation from CNB’s 2% target; contributions in pp
Monetary policy-relevant inflation is inflation to which monetary policy reacts in the forecast. It is defined as headline inflation adjusted for the first-round effects of changes to indirect taxes.
Economic developments abroad had a strong anti-inflationary effect in 2020. Foreign producer prices had the largest impact. They were falling at the time, due to a drop in oil prices at the start of the first wave of the pandemic. Foreign economic activity, hit by the adverse effects of the coronavirus pandemic, acted in the same direction. However, the anti-inflationary effect of the foreign environment gradually decreased in intensity last year and that environment turned inflationary early this year. This was due to growth in foreign producer prices, which was at a historical high. It reflected second-round effects of the pandemic in the form of overloaded global value chains and a surge in energy commodity prices on international exchanges starting last autumn. The inflationary effect of foreign prices has been offset in recent quarters by accommodative ECB monetary policy, as the ECB’s wait-and-see attitude to monetary policy has been exerting latent appreciation pressure on the koruna, and thus downward pressure on inflation, via a widening interest rate differential.
Overall, the domestic economy fostered a positive deviation of inflation from the target. In 2020, its inflationary effect reflected its initial significant overheating and the only gradual cooling of the Czech labour market due to the pandemic. Moreover, the first wave of the pandemic led to a temporary deterioration in labour efficiency, which outweighed the anti-inflationary effect of falling economic activity. However, the domestic economy turned temporarily anti-inflationary in late 2020 and early 2021 as a result of the government’s strict anti-pandemic measures, which curbed household consumption. The effect of the domestic economy reversed again and became inflationary in mid-2021, when domestic demand recovered quickly and consumers willingly accepted rising prices in the post-Covid euphoria and thanks to the previous generous fiscal policy. This allowed firms to raise their prices further and make up for their previous loss of income by increasing their profit margins. In addition, the already strong domestic inflation pressures were joined early this year by a sizeable increase in administered prices caused by a surge in energy prices on international exchanges.
The CNB responded quickly to the anti-inflationary effects of the coronavirus pandemic by slashing interest rates. At its meetings in 2020, the Bank Board repeatedly assessed the uncertainties and risks of the macroeconomic forecasts at the time as being very substantial. The Bank Board considered the course of the pandemic and its economic and price effects to be the main risk. It also took into account other uncertainties relating to the domestic fiscal policy response, internal policy developments in the USA, the manner of the exit of the UK from the EU and the structure of the supply and demand factors underlying inflation. The exchange rate of the koruna, which was highly volatile, was also a significant uncertainty for the Bank Board.
In 2021, the Bank Board continued to perceive the uncertainties and risks of the forecasts as substantial and related mainly to the reopening of the domestic and foreign economies in the context of a constantly changing epidemic situation. Closely related to this was uncertainty about the duration of the disruptions to global value chains and its pass-through to prices. The central bank therefore initially kept interest rates close to zero. However, the expected cooling of the economy did not materialise. This led to inflation staying above the target. From around mid-2021 onwards, the Bank Board communicated upside risks to inflation. At the same time, it identified a risk of weaker anchoring of inflation expectations in an environment of long-running overshooting of the inflation target. The upside risks were later joined by unprecedentedly high growth in energy prices and imputed rent and a weakened reaction of the koruna to the growth in domestic interest rates.
The CNB responded to the exceptionally strong across-the-board inflation pressures by raising interest rates from June 2021 onwards. The rate hikes gained in intensity during the autumn. The aim was to limit the pass-through of these pressures to prices in the longer term, ensure the return of inflation close to the 2% target at the monetary policy horizon and help anchor inflation expectations at the target so that the CNB fulfilled its price stability mandate. In 2021 as a whole, the CNB increased the 2W repo rate by a total of 350 basis points in five steps. It continued to raise interest rates in February and March this year, when the rates went up by a total of 125 basis points in two steps.
Inflation was above the 2% target over the entire period under assessment. From mid-2021 onwards, the inflationary effect of monetary policy was joined by the effect of the overheated domestic economy. It was counterbalanced to only a limited extent by the exchange rate and foreign factors. From this perspective, it can be said that monetary policy should have been much less accommodative in the past.[3]
[1] The previous assessment of the fulfilment of the inflation target was presented in Box 4 in Monetary Policy Report – Spring 2021.
[2] The g3+ core prediction model is used to prepare the CNB’s macroeconomic forecasts. It is also used to assess the fulfilment of previous forecasts and to determine the sources of deviations of the actual figures from the forecasts under assessment and the inflation target. For details, see The g3+ model: An upgrade of the Czech National Bank’s core forecasting framework, CNB WP 7/2020.
[3] The Czech economy had already been strongly overheated for some time before it was hit by the coronavirus shock, which was identified ex post as a negative supply shock. As elsewhere in the advanced world, the government and the CNB responded to the related temporary economic downturn, decline in revenue and risk of a drying-up of liquidity and financial instability by deploying stabilising anti-crisis measures. However, this supportive policy inevitably led to demand stimulation after a time. Such extensive support for demand soon turned out to be strongly inflationary in an environment of economic recovery.