Interview of Aleš Michl, CNB Governor
By Jakub Svoboda (Právo, novinky.cz 1. 7. 2023)
Price growth will continue to slow, so inflation could fall below 10% within two months, Czech National Bank Governor Aleš Michl tells Právo.
It’s a year to the day since you became head of the central bank, but inflation is still in double figures. How do you feel when you hear that?
It’s not nice to hear. But I have encouraging news. The fruits of our labour are now visible: since the autumn inflation has fallen from 18% to 11% in May.
But we haven’t won the war yet. The goal is to have inflation close to 2%. That’s why we have the tightest monetary policy in 25 years – the highest interest rates since 1999 combined with a strong koruna. And we aren’t even thinking about cutting rates or letting up on our fight.
Inflation in the Czech Republic has been in double figures since last February. When will it finally fall back to single-digit levels?
We’ll probably see it drop below 10% within two months. As for the outlook further ahead, as the Bank Board we currently see 2024 as promising for achieving low inflation.
However, inflation may turn out to be more persistent than we think now. If this were accompanied by a recovery in demand, we would increase rates in such case. We can’t underestimate anything. We have to remain strict and be ready for any kind of turnaround or unexpected event.
But the CNB is sometimes criticised for inaction. Didn’t you make a mistake in not raising rates even once over the past year?
We haven’t been inactive. The level of rates either dampens or supports the economy. The current rate level at 7% is dampening the economy. On top of that, the strong koruna policy which we introduced has brought about a substantial change in the fight against inflation. The strong exchange rate has made imports of expensive commodities cheaper and tightened monetary conditions for exporters as well. Large ones in particular were not being influenced very much by our high koruna rate, since they were borrowing in euros. Only in this way have we managed to push down activity across the economy and hence reduce inflation.
The main question that economists and others are asking is whether inflation would have slowed more quickly this year had rates been raised – albeit slightly – in the second half of last year.
We bought a new book by John Cochrane of Stanford University for our library. In it, he shows that if fiscal policy is insufficiently restrictive when high inflation is being tamed, rapid growth in interest rates causes inflation to increase. Without a reduction in debt, the government’s debt servicing costs soar. It covers them by borrowing, which means a further increase in the quantity of money in the economy. Economic agents start to expect this to continue, and all that implies higher inflation.
An excellent paper on the need for monetary policy to be accompanied by restrictive fiscal policy was presented by economists Francesco Bianchi and Leonardo Melosi of the Chicago Fed at the Jackson Hole conference. As for Czech authors, I can refer you, for example, to the papers written by Professor Martin Mandel of the Prague University of Economics and Business.
So, might inflation in the Czech Republic have been falling faster this year had the government started to consolidate public finances last year?
Yes. Had it started to consolidate last year, and had that commitment been sufficiently credible for the public to believe it, it could have reduced aggregate demand in the economy and hence also inflation. This hypothesis has been confirmed by Cochrane and by Bianchi and Melosi and Professor Mandel.
The process is made more difficult by the fact that we’re living at a time which was preceded by a large increase in the quantity of money in the economy, and interest rates were at zero for a long time. That was down to the CNB. It sounds self-destructive, but remember that previously the aim was to create inflation in the Czech Republic. We made a world of surplus money in the economy enabling large fiscal expansion. This is now hampering our ability to reduce inflation.
I agree with Professor Raghuram Rajan of the University of Chicago, who says that more focused, more judicious and less interventionist central banks would probably deliver better outcomes than that of a high-inflation, high-debt, low-growth world. For central banks, less can mean more. Therefore, our strategy in the Czech Republic is to keep interest rates higher for longer and not to give in to any politically motivated pressure.
You’ve been telling us for a year now that interest rates are at a level that’s dampening domestic demand pressures. But this didn’t seem to be working very well early this year…
It’s taking time to tame the growth of money in the economy. I’ll put it another way, using an example from the Czech Republic again. Going back ten years, interest rates were too low, in fact zero for a long time. On top of that, in early 2017, interventions to weaken the koruna caused the CNB’s balance sheet – and the banking sector’s liquidity – to increase from CZK 1.3 trillion to CZK 2.3 trillion within four months.
This further expanded banks’ bond buying options and the country’s borrowing options. Budget constraints were softened. I repeat that the aim at the time was to create inflation. Then, during Covid, in particular in May 2020, interest rates were reduced too close to zero. And fiscal policy was expansionary for too long.
We created a dangerous entitlement economy in which the state was a rich uncle helping with almost everything. When an economy such as this (additionally with incomplete price convergence) was hit by a strong supply-side shock after the Covid lockdowns, the Czech Republic ended up with the highest core inflation rate in the EU between November 2021 and October 2022.
So, what do we need to do to reduce inflation faster?
Inflation is our responsibility. However, we are in this together with the government. We need support from fiscal policy. To reduce inflation, we have to stop increasing the quantity of money in the economy so much through debt. Loans to households and firms have already declined year on year. To secure a long-lasting return of inflation to low levels, it is important for this to be accompanied by a reduction in the country’s debt. We need less debt and more saving. Inflation will then decrease faster.
And what’s the proof that demand in the economy has dropped?
Household consumption, which is crucial for the future course of demand-pull inflation, has been falling in real terms for six quarters in a row and is below the pre-pandemic level. Apartment prices have already fallen year on year due to lower demand. There is no wage spiral in the economy. The average wage grew by 8.6% in nominal terms in the first quarter, but in real terms it fell by 6.7% and has been declining for six consecutive quarters.
For comparison, wages at the CNB were previously linked to inflation. However, we managed to renegotiate this with the unions and the average wage at the bank has risen by 4.5% this year. We’re thus leading by example by showing that inflation clauses can be adjusted by agreement between the contractual parties.
These are steps to prevent a wage spiral, curb demand and hence reduce inflation. We can’t ease off in the wage bargaining for next year either – we simply can’t allow a wage spiral to occur.
But if there’s a shortage of people on the market, wage growth ultimately can’t be prevented…
The public sector, but also we as the Czech National Bank, should streamline and not hoover up people from firms. The public sector employs too many managers and there is overemployment in rank-and-file posts too. We’ll lead by example this year again and streamline the bank’s operation.
You are advocating saving à la Alois Rašín. But how can we prevent saving from dampening the economy, even more so in a situation when we’re in stagflation and some economists think we won’t get out of the crisis any time soon?
We can’t avoid dampening the economy while saving. The reward will be substantially lower inflation.
How can households, which are facing a fall in real incomes for a second consecutive year, save?
I’ve recently seen statistics on how much money is lying idle on low-interest current accounts. If you have savings, go to the bank. Don’t leave them all on a current account, but open a saving or term account. Find out about the regular monthly investments which banks and investment funds offer.
The recent spendthrift governments, the overheated labour market, the war in Ukraine – does this and this alone really still explain why inflation in the Czech Republic has long been almost double the EU average?
This is an accurate and a good question. Few people ask themselves a question such as: The energy shock to prices was similar everywhere in the EU. If we abstract from it, why was core inflation in the Czech Republic actually the highest in the EU between November 2021 and October 2022?
The answer is that the cause was an unprecedented increase in the quantity of money in the banking sector due to interventions to weaken the koruna in late 2016 and early 2017 combined with zero interest rates allowing for easy and cheap borrowing by households and the government in the period that followed.
Do you agree with the frequent claims of analysts that the data coming from the economy is now mostly anti-inflationary in nature?
No. We must be vigilant. There are risks on both sides. We now need to assess above all how much inflation is going down or how much it is resisting, how persistent it is. Depending on this, we need to decide whether to raise interest rates further or leave them unchanged for a time.
What are the main risks now?
The main upside risk to inflation is that the government will fail to reduce the state budget deficit and that the debt of people and firms will start to grow again, followed by a wage spiral and other unexpected events. You know how it goes – forecasts are usually turned on their heads by black swans, i.e. hard-to-predict events such as the fall of Lehman Brothers, Covid and the war over Ukraine.
And if we admit that the war in Ukraine could last several more years?
I can promise on behalf of the CNB that we’ll carefully assess the data and, if inflation is persistent due to the war dragging on, we’ll tighten monetary conditions.
According to some economists, the fact that inflation expectations are anchored high, higher than they should be, is also a problem. Is that so? And what can we do about it?
They aren’t. Inflation expectations are adaptive in the Czech Republic. They went down as inflation decreased. And they’ll go down if we manage to tame inflation further.
Do you still hold the opinion you expressed last year that the current high inflation is mostly imported, mainly through higher energy prices, which lead to growth in prices of almost everything else? Energy prices on markets started to fall sometime in August last year…
Two-thirds of last year’s inflation was imported via expensive energy and problems in supply chains. The increased quantity of money in the economy enabled firms to pass on these costs to consumers and maintain their profitability. Now it’s beginning to be a different story – the goal is to prevent excessive amounts of money being poured into the economy through consumption by the government, firms and households with savings.
Most economists agree that the government’s energy price caps were introduced late and are moreover very high. Is this in your view preventing inflation from falling faster?
It’s not within my competence to comment on that.
Isn’t it the case that retailers, their suppliers and service providers in the Czech Republic took advantage of the situation and overpriced goods for consumers more than elsewhere in Europe?
I attended an excellent conference held by the European Central bank in Sintra. The English word “greedflation”, which means something like inflation caused by firms’ greed, was used there. On the other hand, that’s what capitalism is about. It’s not the cause, but the consequence – the consequence of having a large quantity of money in the system and insufficient competition in some segments. It’s then easier to raise prices That’s why we have curbed lending to firms and households. And that’s why we need the same from the government.
You admitted the possibility of raising rates after the latest Board meeting. But this possibility is probably only very theoretical. What conditions would have to be met for this to occur?
We’ll raise rates if it makes sense to do so and demand-pull inflation needs to be tamed like in the USA and the euro area. This can no doubt happen. Nothing can be ruled out. It isn’t just a theoretical possibility. But just for comparison, let’s look at how tight the individual central banks are – the key rate is 7% in the Czech Republic, 4% in the euro area and 5–5.25% in the USA.
And can we conversely expect rates to be reduced? Maybe still this year?
I know that I don’t know. A majority of the Bank Board members agree that interest rates will stay at the current or a higher level for longer.
What shape do you think the real economy is in? And what’s your outlook for the rest of this year and next year?
It will be an unbearable lightness of being. Exporters and firms will want to get their business moving again, but we and other central banks will dampen demand until we tame inflation.
You said that you are seeing a major slowdown in the property and mortgage markets that is gradually helping to reduce core inflation further. Property prices are decreasing but people aren’t buying. Could this be a harbinger of an economic crisis?
We analyse this in detail twice a year in our financial stability report. According to our analysts, property is overvalued by as much as 57% in some cities, so some correction would do the market good. We are monitoring the property market very carefully and assessing the risks.
Last year, the Bank Board decided to bet on the exchange rate channel, meaning interventions to strengthen the koruna. To what extent has this succeeded?
We have not been intervening for a long time. Although we haven’t further raised the CNB’s repo rate above 7%, we have managed to have a record-strong currency. The average monthly exchange rate of the koruna against the euro was at its strongest ever level in April 2023 – CZK 23.44 to the euro. I will always be proud if we have a strong koruna during my mandate. But we also need a strong economy for that.
We are a strongly export-oriented economy. The performance of the economy is largely based on that. And a strong koruna certainly doesn’t help exporters. Do the pros of having a strong koruna really outweigh the cons?
Yes. A strong koruna means lower imported inflation. Low inflation is the foundation for the functioning of the economy and for the trust of people and firms. Nothing will beat this. Our objective is price and financial stability.
How much of its international reserves has the CNB sold to defend the koruna exchange rate since your appointment?
Between May and October 2022 the CNB sold EUR 25 billion and raised, or withdrew from the market, over CZK 600 billion. It was an anti-inflationary operation. The supply of the koruna decreased.
The market value of the reserves is now around EUR 120 billion. Relative to GDP, we still have one of the highest reserve levels in the world.
Does it therefore appear that verbal interventions are enough? What is keeping the koruna at relatively stronger levels now? Will it remain around CZK 24 to the euro over the entire summer?
We don’t comment on the koruna exchange rate in such detail.
Through the CNB, the Czech Republic has increased its gold reserves by 1.54 tonnes to 13.5 tonnes. Why are you increasing the gold reserves, and what level are you planning to get them to?
My vision is for the CNB to have at least one hundred tonnes of gold in five years’ time, the most in history. We must diversify the reserves. If you want to reduce the risk of a portfolio, you need to have assets with low correlation to each other in it. Gold thus fits well into a large portfolio, complementing equities and bonds.
Why one hundred tonnes? Because it’s a nice round number?
In order to diversify our international reserves portfolio and increase the expected return on the reserves, having around one hundred tonnes of gold came out as best. Most importantly, there will again be a gold treasure for future generations.