MONETARY POLICY REPORT | AUTUMN 2021 (box 4)
(authors: František Brázdik, Jakub Grossmann, Dana Hájková, Eva Hromádková, Petr Král, Branislav Saxa)
The Czech National Bank seeks to maintain price stability, i.e. low and predictable inflation, by setting short-term monetary policy interest rates.[1] How future inflation is influenced by the making of changes to interest rates is described by the “transmission mechanism”. This is a complex process whereby changes in interest rates lead – with a time lag – to effects on the economy and inflation. To better understand the central bank’s influence on inflation, we provide a scheme of the different ways in which changes to monetary policy interest rates pass through to prices. We call them the transmission channels of monetary policy. The following text explains how the most important transmission channels work and, using simulations of macroeconomic models, shows how fast and powerful the effect of raising interest rates is in terms of taming inflation.
Three transmission channels play an important role in the Czech economy: the exchange rate channel, the interest rate and credit channel and the asset price channel. In all these channels, a change in interest rates affects inflation in the same direction: other things being equal, a rate hike reduces future inflation and a rate cut increases it. Chart 1 shows how the different channels work.
Chart 1 – Monetary policy transmission channels
As its name suggests, the exchange rate channel works both directly and indirectly via the exchange rate. An increase in interest rates results in a higher demand for assets denominated in the Czech currency, which is reflected in higher demand for the koruna and its appreciation against other currencies. The appreciation leads to lower prices of imported goods intended for consumption and subsequent production. This slows growth in domestic consumer prices. Along with this direct price effect, domestic and external demand for domestic products declines in favour of foreign products due to an increase in the price of the former relative to the latter (“intratemporal substitution”). This leads to lower growth in domestic economic activity and a cooling of the labour market, which also acts in the desired anti-inflationary direction. In a small open economy such as the Czech Republic, both the direct and indirect exchange rate channels play an important role in the transmission mechanism.
The interest rate and credit channel works owing to the interconnectedness of the CNB’s monetary policy rates and market and client interest rates via the central bank’s monetary policy operations, which affect the interbank money market. A rise in CNB monetary policy rates increases the price of money in the economy, which generally leads to a preference for future consumption over current consumption (“intertemporal substitution”). In practice, this means, among other things, that growth in monetary policy interest rates will be reflected in higher bank client rates on loans and deposits. In such conditions, firms revise their investment plans due to a decline in the profitability of the most risky and financially controversial projects. Their debt management costs will also rise. Thus, there is a decrease in corporate demand for investment and investment-financing loans. This will be reflected in lower production by domestic producers of capital goods. When the cost of money (i.e. client interest rates on deposits) increases, households start to favour saving over immediate consumption. At the same time, consumer credit becomes more expensive, which also results in lower demand for debt-financed consumption of goods and services. This further dampens economic activity and leads to a slowdown in wage growth and the taming of inflation.
The asset price channel acts through changes in the pricing of financial and non-financial assets such as securities and property. Other things being equal, a rise in interest rates causes asset prices to fall, because the higher interest rates reduce the expected rate of return. Assets therefore become less attractive than better remunerated bank deposits. The fall in current market asset prices represents a decline in households’ perceived wealth, which will be reflected in a reduction in their consumption. Firms engage in more prudent investment activity. Overall, this leads to slower growth in economic activity due to lower demand and thus again to a slowing of excessive inflation.
Besides the three channels described above, monetary policy affects future inflation via the inflation expectations of households and firms. Through its actions and communications, a credible central bank consistently shows that despite temporary fluctuations, inflation will return to the target. Steering households’ and firms’ expectations in this way is essential for successful monetary policy in the long term. For the central bank to maintain its credibility, in the event of a significant threat of deviation of inflation from the target it must not delay and must use the tools available to it to fulfil its mandate, return inflation to the inflation target and keep inflation expectations anchored.
The overall effect of interest rate changes on inflation is the sum of the individual effects of the above transmission channels. In the economic literature, simulations of macroeconomic models are usually used to quantify the extent and timing of the effects of interest rate changes on economic and price developments. One of them is the CNB’s core forecasting model, g3+.[2] The structure and parameters of g3+ were chosen (calibrated) to ensure that the model is capable of accurately describing the behaviour of the Czech economy and inflation in an environment where the CNB conducts inflation targeting monetary policy. The CNB’s forward-looking monetary policy in the g3+ model is described by a monetary policy rule whereby the short-term interest rate is a function of the deviation of predicted inflation from the inflation target. The impulse responses to an unexpected shock to the monetary policy rule reveal that the exchange rate channel is also the fastest transmission channel in the g3+ model, due to an immediate widening of the interest rate differential vis-à-vis the rest of the world.[3] The transmission of a monetary policy shock via the interest rate and credit channel is delayed due to inertia in households’ consumer habits and firms’ demand for labour and capital. Households and firms thus adapt at a slower pace. The resulting impact on inflation therefore peaks with a lag, in contrast to the immediate response of the exchange rate.
To test the calibration of g3+, its properties are confronted with those of structural econometric models estimated on data. For the purposes of this box, the estimate of the impact of interest rate changes on inflation was quantified using a structural VAR (SVAR) model for the Czech economy estimated using the Bayesian approach.[4] The SVAR model uses the monthly seasonally adjusted industrial production series, the deviations of inflation from the inflation target, 3M PRIBOR interest rates and the CZK/EUR exchange rate. The model also includes the 3M EURIBOR and a foreign energy price index as exogenous variables to capture the impact of the rest of the world on the Czech economy. The estimate is performed for the period January 2000–August 2021.
Chart 2 depicts the median impulse responses of the SVAR model over a 36-month period (the blue line in the charts) along with their 68% and 95% confidence intervals (the red and yellow dashed lines in the charts respectively). The impulse responses show the extent and speed of the changes which occur in the economy in response to a monetary policy shock in the form of an unexpected rise in interest rates (restrictive monetary policy). This will be reflected initially in rapid appreciation of the exchange rate, followed by a fall in industrial production and a decline in inflation. According to this empirical model, an increase in interest rates of 1 pp leads to a decline in inflation of about 0.4 pp. The impact peaks in 20–24 months. This is slightly longer than the standard monetary policy horizon.
Chart 2 – An increase in interest rates of 1 pp leads to a decline in inflation of about 0.4 pp
impulse responses to interest rate increase of 1 pp; x-axis shows months
Industrial production
index; deviation in %
Inflation
headline inflation; y-o-y; deviation in pp
3M PRIBOR
% p. a.; deviation in pp
Nominal exchange rate
CZK/EUR
According to the g3+ model, the impact of an unexpected rise in interest rates will peak about four quarters after the materialisation of this monetary policy shock. In the SVAR model, the peak is reached around the seventh quarter. Both models are thus consistent with the definition of the CNB’s monetary policy horizon. Due to the lower persistence of g3+ compared to the SVAR model, a one-quarter shorter period for the return of inflation to the target as its steady-state value is also observed.
The two models identify almost the same initial magnitude of the impact of a rise in interest rates on the exchange rate. In both cases, the initial strengthening of the exchange rate is followed by a correction. In g3+, however, the initial impact dissipates faster, in fact about one quarter earlier than in the SVAR model. The profile of the return of industrial production to equilibrium corresponds to the duration of the impacts of restrictive monetary policy on growth in economic activity in g3+, where the peak impact fades after about one year. The peak impacts are achieved more quickly in g3+ due to its explicit forward-looking nature, in contrast to the SVAR model, and to a faster return of interest rates to equilibrium (as measured by the response of 3M PRIBOR rates).
The empirical estimate based on the SVAR model confirms that the CNB’s monetary policy based on the g3+ forecasting model can rely on an increase in interest rates truly leading to the desired decline in inflation, with the peak impact occurring about two years ahead. In the current period of exceptionally high price pressures, a decisive and immediate response by the CNB in the form of an increase in interest rates will also ensure that its monetary policy remains credible and that inflation expectations remain anchored to the inflation target and do not contribute to higher inflation in the long term.
[1] The CNB uses three monetary policy rates: the 2W repo rate, the discount rate and the Lombard rate. More information about these rates is available on the CNB website: https://www.cnb.cz/en/monetary-policy/instruments/.
[2] The g3+ model and the motivation for its introduction into the CNB’s forecasting process in 2019 are presented in a July 2019 blog article “The CNB’s prediction model gets a new plus”: https://www.cnb.cz/en/about_cnb/cnblog/The-CNBs-projection-model-gets-a-new-plus/. The structure and properties of the core forecasting model are described in detail in F. Brázdik, T. Hlédik, Z. Humplová, I. Martonosi, K. Musil, J. Ryšánek, T. Šestorád, J. Tonner, S. Tvrz and J. Žáček: “The g3+ Model: An Upgrade of the Czech National Bank’s Core Forecasting Framework”, WP 7/2020; see https://www.https://www.cnb.cz/en/economic-research/research-publications/cnb-working-paper-series/The-g3-Model-An-Upgrade-of-the-Czech-National-Banks-Core-Forecasting-Framework-00001/. The forecasting experience and the functioning of the model during the Covid-19 pandemic are presented in a September 2020 blog article “Model g3+ boduje”; see https://www.cnb.cz/cs/o_cnb/cnblog/Model-g3-boduje/ (available in Czech only).
[3] See CNB WP 7/2020, p. 58, Figure E7a. Further details on transmission can also be found in this research paper.
[4] A more detailed description of transmission and other related estimates is available, for example, in CNB Research and Policy Note 1/2013. Babecká Kucharčuková, O., Franta, M., Hájková, D., Král, P., Kubicová, I., Podpiera, A., and Saxa, B. (2013): What We Know About Monetary Policy Transmission in the Czech Republic: Collection of Empirical Results.