MONETARY POLICY REPORT | WINTER 2023 (box 3)
(authors: Tatiana Keseliová, Tomáš Pokorný, Jan Syrovátka, Stanislav Tvrz, Jan Žáček)
The CNB’s price stability mandate involves regularly assessing the fulfilment of the mandate and determining the causes of any past deviations of actual inflation from the central bank’s inflation target. In the interests of making the CNB’s monetary policy transparent to experts and the general 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 over the past two years, i.e. in 2021–2022.
In 2021, inflation started to deviate increasingly from the CNB’s 2% target. At the start of 2022, it even climbed to double figures (see Chart 1). The factors underlying the deviation of inflation from the target were identified using the core prediction model.[2] This identification provides an insight into the origin of the inflation pressures faced by the Czech economy in the past two years (see Chart 2).
The monetary policy rule in the g3+ model sets interest rates so as to ensure that inflation returns to 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 excessive 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 term. This is usually accompanied by gradual movement of interest rates towards their neutral long-run level (3%).
Chart 1 – Inflation gradually deviated from the 2% target during the period under review, reaching double figures in 2022
consumer prices in %
Chart 2 – The significant and increasing overshooting of the target in 2021 and 2022 was due mainly to an overheating domestic economy, high energy prices and previous easy 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 an anti-inflationary effect in 2021, albeit with gradually decreasing intensity. This predominantly reflected the lingering effect of the fall in foreign producer prices in 2020, which fed through to domestic price pressures with a lag. In spring 2022, the foreign environment slowly started to gain inflationary momentum. This was due to record-high growth in foreign producer prices in the effective euro area. It reflected second-round effects of the pandemic in the form of disrupted global value chains and a surge in energy commodity prices on international exchanges. The latter was exacerbated by Russia’s aggression against Ukraine, which fuelled the already enormous rise in energy commodity prices (energy crisis). An inflationary effect of foreign prices on the Czech economy was identified for most of the period under review. However, its impact was partly dampened by appreciation of the koruna related to the slower tightening of the ECB’s monetary policy, as the ECB started to raise interest rates later (in July 2022) and with less intensity by comparison with the domestic monetary tightening. A widening interest rate differential thus exerted latent appreciation pressure on the koruna and hence downward pressure on domestic inflation.
The domestic economy had a slight anti-inflationary effect at the start of 2021 but began to contribute positively to the deviation of inflation from the target in the spring. The government reintroduced anti-pandemic measures at the start of 2021 during the third (winter) wave of Covid-19. These measures curbed household consumption and had an anti-inflationary effect. In mid-2021, however, the contribution of the domestic economy turned inflationary as domestic demand quickly recovered after most anti-pandemic restrictions were lifted. Along with deferred consumption and forced savings, demand was boosted by the abolition of the super-gross wage and by other generous fiscal measures amid a still highly overheated labour market and low unemployment. Households therefore accepted rising prices, thanks in part to strong consumer appetite. This allowed firms to raise their prices further and make up for their previous pandemic-related losses by increasing their profit margins. In addition, the already strong domestic inflation pressures were joined in late 2021 and early 2022 by a sizeable increase in administered prices caused by a surge in energy prices on international exchanges. This continued for the rest of 2022. The broad-based nature of inflation – which, together with the rapid growth in costs, reflected rising profit margins in sectors that had not been affected so much by the rise in energy prices, or had even profited from it – also contributed to the significantly positive and further increasing deviation of inflation from the target for most of 2022. The deviation of inflation from the target narrowed at the end of 2022 as a result of a government measure to counter the high energy prices – the energy savings tariff (including a waiver of the fee for renewable energy sources), which temporarily reduced administered price inflation.
The koruna depreciated sharply to CZK 27 to the euro in spring 2020. This was due to a sudden deterioration in sentiment and to the high degree of uncertainty associated with Covid-19. The koruna then appreciated markedly from its previous temporarily weaker levels as the pandemic receded during 2021. It thus fostered a negative deviation of inflation from the target from the second half of 2021 onwards. Despite a renewed deterioration in sentiment as a result of the energy crisis and the war in Ukraine, the koruna remained relatively stable in 2022, due in part to the CNB’s foreign exchange interventions. It strengthened further at the year-end, mainly on the back of improved financial market sentiment towards the region. This stemmed among other things from the securing of sufficient gas stocks for the current heating season amid favourable temperatures. The appreciation of the koruna thus partly offset the surge in import prices and had an anti-inflationary effect.
In 2021, the Bank Board viewed the uncertainties and risks of the CNB’s forecasts at the time mostly 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 their pass-through to prices. The central bank therefore kept interest rates close to zero at the start of 2021. However, the expected cooling of demand-pull inflation pressures did not materialise, due in part to fiscal measures. This led to inflation staying above the target. From around mid-2021 onwards, the Bank Board communicated the upside risks to inflation of the forecasts. 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 already sharp rise in energy commodity prices intensified in early 2022 due to the outbreak of the war in Ukraine. There was also a related risk of more expansionary domestic fiscal policy (measures aimed at mitigating the impacts of the energy and refugee crises). The future monetary policy stance abroad was a significant uncertainty. In the second half of the year, the Bank Board assessed the risks and uncertainties as being significant and going in both directions. The growing likelihood of recession abroad and a stronger-than-forecasted downturn in domestic consumer and investment demand were newly identified risks.
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 and continued until June 2022. 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 to the target so that the CNB fulfilled its price stability mandate. Overall, the CNB Bank Board increased the two-week repo rate by 675 basis points to 7% in nine steps during this period.
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/labour market and by high growth in energy prices, which gradually fed through to all price categories. It was counterbalanced to only a limited extent by the anti-inflationary effect of the exchange rate and – until the start of 2022 – also by foreign factors (mainly the pass-through of the previously falling foreign producer prices to domestic inflation). 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 3 in Monetary Policy Report – Spring 2022. Starting with this Report, this analysis will be part of the winter issue of the Report.
[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 Covid-19 pandemic, which was identified in hindsight as a negative supply shock. The CNB’s response in the form of stabilising anti-crisis measures (including a sharp reduction in interest rates and the relaxation of limits in the financial stability area) was similar to the course of action taken by most central banks in advanced countries. In the context of other factors (including relaxed fiscal policy), this supportive policy nonetheless led to excessive stimulation of demand and soon proved to be too inflationary. The following study deals in detail with the overheating of the Czech economy in the Covid period: Assessment of the Nature of the Pandemic Shock: Implications for Monetary Policy, CNB Research Policy Notes 1/2022.