February 1, 2017
If euros continue to flow into the balance sheet of the Czech National Bank (CNB) at the rate they have been doing last month, the central bank may soon get into a situation where it will no longer be willing to buy any more euros. This will give rise to a “Swiss-style” exit from the CNB’s exchange rate commitment before the end of the first quarter of this year.
Read an opinion piece by our Managing Partner David Vavra.
The latest inflation figures have accelerated the course of events and reduced the time for manoeuvring. If euros continue to flow into the balance sheet of the Czech National Bank (CNB) at the rate they have been doing in early January, the central bank may soon get into a situation where it will no longer be willing to buy any more euros. This will give rise to a “Swiss-style” exit from the CNB’s exchange rate commitment before the end of the first quarter of this year. The underlying reason will be the same. The CNB’s balance sheet will reach a point where the amount of forex reserves relative to currency in circulation will lead to future explosive growth in the CNB’s loss. We’re not talking here about the loss that will arise the instant the commitment is abandoned – that is not so important. Rather, the structure of the CNB’s balance sheet will be such that the bank will not be able to cover its loss from its future profits.
Does that scenario strike you as far-fetched? Well, many things have happened in the world of central banks and money that no one could have imagined, and that includes the Swiss exit. All the talk is about the ratio of forex reserves to GDP, but that does not play a major role. What you need to follow is the ratio of reserves to currency in circulation. The CNB’s balance sheet is meanwhile more sensitive than the Swiss National Bank’s, because the CNB will sooner or later face equilibrium currency appreciation connected with convergence of the Czech economy.
We can therefore say without any great exaggeration that we are currently on the threshold of the final chance to break the financial markets’ future appreciation expectations and put an end to the huge speculative bubble on the Czech koruna. The only way to do so is to change the current expectations of a future appreciation into expectations of future currency stability or, better still, at least a modest depreciation.
This situation of massive market speculation on a currency appreciation in an environment of negative interest rates is unique. The speculative position may balloon to an unimaginable size, so we need to be innovative and enter uncharted territory. We have an academic concept at our disposal and we should not be afraid to use it: Svensson’s “Foolproof Way” of escaping from a liquidity trap and deflation. The very introduction of the exchange rate commitment three years ago was motivated by this concept, and the CNB has won great renown in international economic circles for its innovative use of it. Svensson’s Foolproof Way simultaneously assumes a temporary switch to price-level targeting.
However complicated it may sound, there is nothing very complex about switching to price-level targeting. On the outside it involves no great change. Instead of 2% inflation, you start targeting 2% growth of the price level. CPI inflation will thus stay at 2% – something that certainly cannot be said about average inflation over the last few years. There can be no talk of dynamic inconsistency. No one is suggesting that the CNB should give up price stability in favor of supporting GDP growth or attaining some real exchange rate level.
So how do you go about it? In the first step you change the forecasting system so that the paths of your monetary policy instruments target a specific future CPI level and not inflation. This will not take long and is a straightforward technical exercise. The rest is more or less about your way of thinking, as you have to learn to think in deviations from the price level and consider their impacts on inflation. You also have to add to your first forecast the initial negative difference between where the price level is now and where you want it to be, so that the koruna does not have any fundamental macroeconomic reason to strengthen after you exit the commitment. This difference can easily be calculated from the difference between inflation in the Czech Republic and that in the eurozone since November 2013 and the estimated change in the equilibrium real exchange rate since the same date.
Let’s say, then, that we are roughly three percent below the targeted price level and that that level is itself rising at a rate of two percent. We then set monetary policy so that the inflation forecast climbs above two percent until we erase the three percent difference in the price level, and then the forecast continues with an average inflation rate of two percent.
You subsequently need to publish this inflation forecast complete with the projected exchange rate path. The latter is especially important, because it clearly demonstrates that the new monetary policy regime is not consistent with any post-exit currency appreciation and that any appreciation that does occur will be due solely to the long-term process of catching up with advanced countries.
What is more, this approach greatly increases the CNB’s room for manoeuvre. The present approach is delivering monetary policy easing through negative nominal rates, whereas with price-level targeting you can achieve the same degree of easing at positive nominal rates thanks to higher inflation expectations. This is because higher inflation expectations will cause real interest rates to be sufficiently low even when nominal rates are back above zero. The higher inflation will simultaneously reduce real interest rates to such a degree that, given the expected future stability of the currency, it will no longer be rational to hold speculative positions against the CNB. Those positions will be closed and the currency will weaken below CZK 27 to the euro. At that moment, the CNB will also be able to offload at least part of its forex reserves.
In short, what we have here is a practical and dynamically consistent way of ending the speculation on the koruna and returning to “normal” monetary policy.
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