Monetary policy of the Czech National Bank

Principles, procedures, instruments

Would you like to know a bit more about the Czech National Bank than what you can find in the newspapers? The following fact sheet will guide you around the world of the CNB. It's a world hat may seem unremarkable, but the CNB's work is in many respects crucial to the Czech economy.

According to the Czech Constitution, the CNB's primary objective is "to maintain price stability" . Without prejudice to this primary objective, the Czech National Bank is also tasked with supporting the "general economic policies of the Government leading to sustainable economic growth" . This means that the CNB should set its main policy instrument, namely interest rates, at a level that will maintain inflation at a low and stable level without needlessly slowing, or excessively accelerating, the economic growth rate.

High inflation damages the economy

The objective of achieving and maintaining low and stable inflation is based on international experience that high and volatile inflation damages the economy. It causes this damage by creating uncertainty and forcing money holders to focus on short-term projects. Economic growth, meanwhile, is founded primarily on longer-term investment. High inflation also hampers inflation forecasting and thus introduces various distortions into the economy: it changes the real value of debtors' liabilities to their creditors, creates distortions in the tax system, causes interest rates to be volatile (leading in turn to swings in the inflow and outflow of short-term risk capital and hence to exchange rate fluctuations), and so on.

Savers are also often unaware that high inflation erodes the value of their savings. The economic value of low inflation is also demonstrated by the fact that maintaining inflation at low levels is currently the primary objective of central banks in the majority of the advanced nations, including the European Central Bank. Low inflation is also important in the context of the Czech Republic's integration into European economic structures, as it is one of the conditions for joining the euro area and introducing the euro.

The CNB is an independent and open institution

In the pursuit of its statutory objective, the CNB has a high degree of independence from political influence. Above all, it is independent in making decisions on the settings of monetary policy instruments. Its independence is also reflected in the manner in which its top officers are elected and dismissed (they are appointed and - under very strict conditions - dismissed by the Czech President).

The CNB's independence protects it primarily from any political pressure to adopt measures to boost short-term economic growth, for instance in the run-up to a general election. Such measures would in the longer term cause an undesirable rise in inflation, while growth in economic activity would soon return to its original level, or even fall below it (as a result of the increased inflation).

The CNB's high degree of independence is counterbalanced by openness with respect to disclosure of information. The CNB uses various channels to inform the public about its monetary policy system, its inflation target, its inflation forecasts and the attendant risks, and about its monetary policy measures and its reasons for adopting them. To inform the public, the CNB not only issues quarterly Inflation Reports, which are submitted to the Chamber of Deputies (the lower house of the Czech Parliament) and published on the CNB's website, but also releases minutes of the CNB Bank Board's monetary policy meetings, holds press conferences, publishes articles and gives interviews in the press and other media, arranges presentations and speeches by Bank Board members, and so on.

The CNB steers inflation towards the official inflation target

Since January 1998, the CNB has conducted its monetary policy within an inflation targeting system. Putting it simply, the CNB has undertaken to try to maintain inflation under normal external economic conditions on course for an announced inflation target. This system has some significant advantages over other monetary policy regimes (such as money targeting and exchange rate targeting). First of all, it focuses directly on controlling inflation, a variable that is explicitly mentioned in the CNB Act. This central bank commitment in the form of an inflation target is generally intelligible to the public and provides an anchor for inflation expectations. Figure 1 illustrates inflation targets since the start of inflation targeting in the Czech Republic.

Figure 1: The CNB's inflation targets

Monetary policy needs to be forward-looking

Owing to the lag that arises between the implementation of a monetary policy measure and its greatest impact on inflation, the CNB's monetary policy decision-making is guided not by the present situation but by the forecast for the future - rather like someone deciding what to put on when leaving home in the morning not according to the weather outside but according to the forecast for the whole day. Consequently, the CNB concentrates on the period about 12-18 months ahead (the so-called monetary policy horizon) in its monetary policy deliberations, although of course it also takes into account developments before and after this period.
The forecasts for inflation and the economy as a whole are based on past and present developments, on assumptions regarding several key variables, and on a number of models of the Czech economy. The results generated by such models are then subject to discussion and possible adjustment by the CNB's experts.
The models are based on the CNB's knowledge of how strongly - and with what kind of lag - developments in the external environment (such as changes in inflation or economic growth in other countries and world prices of raw materials), price-related administrative decisions made by Czech state and local authorities, and, in particular, changes to the CNB's interest rates, pass through into various areas of the economy and ultimately into inflation. The two most important channels whereby changes to the CNB's rates affect the economy run via client interest rates and via the exchange rate. Client interest rates, i.e. the lending and deposit rates that commercial banks offer to households and firms, move in step with changes in the CNB's rates (see below). Client interest rates in turn affect demand - i.e. how much households consume and firms invest and, conversely, how much both groups save. The exchange rate also usually reacts to changes in the CNB's rates, especially if such changes are sizeable and are perceived as long-term. The exchange rate in turn strongly affects prices of imported goods and hence inflation.
With a longer lag it also affects exports and imports, aggregate demand and, again, inflation. The key model, known as the quarterly prediction model, also takes on board - in a simplified, model way - the behaviour of the central bank itself which is consistent with its statutory objectives. The overall forecast therefore includes the projected path of interest rates. In its materials for the public, the CNB calls this projection the "interest rate trajectory consistent with the overall forecast". The interest rate projection indicates the central-bank interest rate policy that is consistent with the economic outlook and the inflation target. However, it should not be understood as a binding commitment by the CNB as regards the current and future level of interest rates. It simply serves as a guide for real monetary policy decision-making. The arrival of new information since the forecast was drawn up and different views of the board members of economic developments than those outlined in the CNB forecast mean that the actual interest rate path may deviate from the forecasted path.

Why is the inflation target sometimes not hit?

Despite carefully considered monetary policy decisions, inflation can move outside the inflation target tolerance band for a time. This happens mainly when such decisions are based on predictions that fail to materialise. Economic forecasting is a very difficult business, and all macroeconomic forecasts - not just those drawn up by the CNB - can turn out to be wide of the mark to a greater or lesser extent.
The most frequent - although by no means only - cause of failures of macroeconomic forecasts is a sharp change in the value of some external variable of relevance to Czech inflation. Such variables, which include world prices of raw materials and food, can be predicted only with a high degree of uncertainty. But they have regular and discernible impacts on Czech inflation, as evidenced by the nation's rather volatile inflation history (see Figure 2). In past years, difficult-to-predict changes to regulated prices, fees and indirect taxes have also played a major role in determining inflation.

Figure 2: Inflation in the Czech Republic (annual growth in consumer prices in %)

Imagine that an external shock has caused inflation to move outside the inflation target tolerance band over the coming quarters. The CNB could, of course, respond by dramatically changing its monetary policy instruments to force inflation back into this band. However, such a response could result in an undesirable destabilisation of the economy. Moreover, we need to consider whether the manifestations of the shock in the first few quarters - known as its first-round effects - are in fact essential changes in relative prices which ought not to be suppressed, i.e. the economic and price system is adjusting to the new situation by means of such changes, meaning that strictly speaking they are not changes in inflation at all.
If such first-round effects are very strong, the official inflation rate can depart from the inflation target tolerance band. For these reasons the CNB - like other inflation-targeting central banks - repeatedly tells the public in its publications that there may be situations where it is economically right to accept temporary non-fulfilment of the inflation target. The CNB's monetary policy is focused on suppressing the second-round effects of the shock, which can emerge later as unwanted and genuinely inflationary "echoes" of the first-round effects.

The inflation forecast takes several weeks to draw up

The key source material for the CNB Bank Board's decisions is the CNB's macroeconomic forecast. This forecast is drawn up by the Monetary and Statistics Department in interaction with the board members. It represents the CNB experts' views of the most likely future evolution of the economy, including the behaviour of the central bank itself. The forecast is based on a consistent medium-term framework taking the form of a model approach which is supplemented with an expert opinion primarily affecting the short-term forecast horizon. The most relevant for monetary policy decision-making is the inflation forecast at the monetary policy horizon about 12-18 months ahead.

The forecast is prepared by a large team of specialists working in the CNB's prediction team. The process of compiling the forecast takes about one month, taking the form of a series of meetings of the prediction team. The initial meetings deal with the starting conditions of the forecast, in particular the position of the domestic economy in the business cycle, and the equilibrium values of key variables such as interest rates, the exchange rate, gross domestic product and real wages. The settings of the starting conditions and equilibrium values largely determine the message of the forecast. For this reason, the Bank Board is also involved in this discussion by means of a "meeting on the starting conditions and equilibrium values".

Expected external economic developments are another important assumption of the CNB forecast. To estimate the future evolution of the external environment (prices of energy-producing materials, producer price indices abroad, the business cycles of the Czech Republic's major trading partners and the euro-dollar exchange rate), the CNB draws on the publication Consensus Forecasts, which brings together the forecasts of a whole range of foreign analytical teams, and market outlooks.

Alongside the estimate of the starting conditions, the initial meetings of the prediction team also deal with the so-called short-term forecast, which is drawn up using single-equation and more sophisticated models and expert judgments and which describes economic developments in the coming few quarters.

The short-term forecast for the next quarter is then entered into the core medium-term prediction model, which is made up of around 20 core equations and about 100 auxiliary ones. The equations describe the key relationships within the Czech economy and between the Czech economy and the rest of the world. One of the core equations models the response of short-term interest rates to changes in inflation and to the position in the business cycle (the so-called output gap). This central bank response sends the economy back to equilibrium in the medium term and gradually returns inflation to the CNB's target. The forecast generated by the core prediction model is again subject to expert debate in the prediction team and to other potential expert adjustments. This process of integration of the expert and model views of future economic developments is the most demanding and time-consuming part of the forecasting process. At the end of this process we obtain the final version of the baseline scenario of the CNB's macroeconomic forecast.

The forecast may therefore be viewed as the outcome of model and expert procedures, detailed considerations of short-term shocks, and comprehensive considerations of medium-term and long-term trends. Along with the preparation of the most likely economic scenarios, however, the main uncertainties and risks associated with the baseline scenario of the forecast (e.g. regarding external developments, the evolution of public budgets, uncertainties regarding equilibrium values or the future development of key variables, etc.) are also discussed. On the basis of this discussion, specific alternative scenarios for the macroeconomic forecast can then be formulated at a second meeting with the Bank Board - a "meeting on alternative scenarios". The baseline scenario and any alternative scenarios are then described in the Inflation Report, which is published eight days after the forecast has been discussed at the relevant monetary policy meeting of the Bank Board. A more detailed description of the forecast is then given in the Situation Report, which is an internal document intended for the Bank Board's decision-making and which is published six years later.

Click here for the latest CNB forecast.

The Bank Board makes decisions on the basis of Situation Reports

The situation in the Czech economy does not usually change fast enough to warrant this very time-consuming forecasting process each and every month. The forecast is thus prepared by the Monetary and Statistics Department once a quarter, so that important statistical data published quarterly can also be incorporated. The forecast is submitted to the supreme governing body of the CNB, the seven-member Bank Board, in an internal document entitled the Situation Report on Economic and Monetary Developments as a key material for its monetary policy decision-making at the beginning of February, May, August and November. In the event of extraordinarily dramatic developments in the economy a new fast-track forecast can also be put together in the interim.

The Bank Board meetings are held regularly eight times a year, however; besides the aforementioned months the Board meets also at the end of March, June, September and December. In these months, the Situation Report does not contain a new forecast but provides comparison of the latest key macroeconomic figures with their forecast values, evaluates the situation with respect to the possible future course of inflation, and updates the uncertainties and risks attaching to the most recent forecast.

The Bank Board meeting usually begins at 9 a.m. with a discussion of the Situation Report, which is always presented to the Bank Board by the Monetary and Statistics Department several days in advance. The board is also provided with the Monetary Policy Recommendation of the Monetary and Statistics Department and an opinion on the Situation Report drawn up by one of its advisers. The Monetary Policy Recommendation contains arguments for the setting of higher/lower interest rates compared to the message of the baseline scenario of the current forecast and a recommendation by the Monetary and Statistics Department regarding the optimum monetary policy action and the communication thereof.

The discussion of the Situation Report at the Bank Board meeting opens with presentations by the Monetary and Statistics Department summing up the main ideas and the message of the forecast, the Situation Report and the Monetary Policy Recommendation. The presentations end with the formulation of the Monetary and Statistics Department's own recommendation for the Bank Board in the area of the immediate interest rate settings and communication. Once the presentations are over, the members of the Bank Board are free to ask questions. In the final phase of the meeting, the Board goes into closed session to discuss the risks and uncertainties of the current forecast and the overall monetary policy context and to subsequently vote on the monetary policy action. This vote is not necessarily always unanimous and the final decision can differ from the message of the current forecast and from the Monetary and Statistics Department's monetary policy recommendation.

The measures adopted are immediately disclosed in a press release and explained and expanded upon at an afternoon press conference, at which the ratio of the votes cast is also disclosed. A more detailed account of the discussion leading up to the Bank Board's decision is published eight days later in the minutes of the meeting. The votes cast by the board members on interest rate changes are given also by name in the minutes. When the CNB's new quarterly forecast is published (in February, May, August and November), a forecast for key economic variables (headline inflation, monetary-policy relevant inflation, gross domestic product and the forecast-consistent interest rate path) is also disclosed at the press conference held on the day the decision is made and on the CNB website. The full minutes of the meeting and the situation report are published six years later.

The CNB employs standard instruments in its monetary policymaking

To implement its monetary policy decisions the CNB currently makes exclusive use of standard, " indirect", non-administrative instruments. In other words, the CNB makes monetary policy not by means of orders, prohibitions, limits and suchlike, but by offering banks business transactions and commercial terms formulated in such a way that those banks in turn offer their partners transactions under terms the CNB views as desirable at that particular moment. Through this basic mechanism, and via the channels described earlier (i.e. via client interest rates, the exchange rate, etc.), the CNB's monetary policy aims gradually spread through more and more markets and transactions into the entire economy.

The parameters and structure of the CNB's instruments are almost fully harmonised with those of the European Central Bank. The main instrument is the two-week repo rate. Banks have the option of depositing their excess liquidity at the CNB for a two-week period on the basis of repurchase agreements ("repos") at a rate not exceeding the two-week repo rate. By changing the repo rate, the CNB influences short-term interest rates on the interbank market. This signal then spreads to interest rates throughout the economy, to economic activity and ultimately to inflation.

The CNB changes another two key interest rates (the Lombard rate and the discount rate) automatically in step with the repo rate. Many central banks - particularly in past decades - have also employed "required reserves" as an instrument of monetary policy. This instrument requires banks to hold a specified percentage of the deposits they accept on zero-notice accounts at the central bank. However, the CNB - in keeping with the worldwide trend - no longer uses required reserves for monetary policy purposes. Although banks are still required to hold a small percentage of their deposits at the CNB, these funds - remunerated at the repo rate - serve as a cushion for the smooth running of the interbank payment system at CNB Clearing. Where necessary the CNB executes foreign exchange interventions, i.e. purchases/sells Czech currency in exchange for foreign currency on the foreign exchange market, primarily to reduce volatility in the koruna exchange rate.

The Czech Republic's accession to the EU and subsequently the euro area will affect the CNB

The Czech Republic's accession to the European Union and its expected subsequent introduction of the euro are of crucial importance to the Czech economy and will have far-reaching consequences in a whole range of areas. From the CNB's point of view, the fact that its monetary policy instruments are - as mentioned earlier - almost fully harmonised with those of the European Central Bank is highly important. Upon the accession of the Czech Republic to the European Union and the Economic and Monetary Union, the CNB has become part of the European System of Central Banks. However, until the euro is introduced and the CNB becomes part of the "Eurosystem", the CNB will continue to conduct monetary policy autonomously.
The Czech Republic has the status of "Member State with a derogation" regarding the adoption of the euro, meaning that it will introduce the single currency later on. By adopting the euro it will become a member of the "euro area" (or "eurozone"), which currently consists of 15 of the 27 EU countries. For EU Member States, joining the euro area is conditional on fulfilling the "Maastricht convergence criteria". This is a set of requirements defining areas in which the candidate countries must converge towards the euro area economies (See the Table below). The Czech economy is already compliant with most of the requirements. Its main challenge for the future is to reduce its public finance deficit. Under the current conditions, before the Czech Republic can introduce the euro the koruna must have participated successfully in the ERM II exchange rate mechanism for at least two years. Successful participation means announcing a central exchange rate ("central parity" ) and then maintaining the actual exchange rate within a set fluctuation band around the central parity for the entire examination period.

Joining the euro area will strengthen the macroeconomic stability of the Czech economy and generally speed up the real convergence of the Czech economy towards the EU economies. The CNB is therefore convinced that the Czech Republic should join the euro area as soon as economic conditions allow for doing so. A necessary condition for this is a reform of the public finance system and more profound structural reforms, such as improvements to the functioning of the labour market.