The Czech interest rate fallacy and exchange rates

For many years Ludek Niedermayer was deputy central bank governor of the Czech central bank (CNB). Ludek did an outstanding job at the CNB where he was a steady hand on CNB’s board for many years. I have known Ludek for a number of years and I do consider him a good friend.

However, we often disagree – particularly about the importance of money. This is an issue we debate whenever we see each other – and I don’t think either of us find it boring. Unfortunately I have so far failed to convince Ludek.

Now it seems we have yet another reason to debate. The issue is over the impact of currency devaluation and the monetary transmission mechanism.

The Czech economy is doing extremely bad and it to me is pretty obvious that the economy is caught in a deflationary trap. The CNB’s key policy rate is close to zero and that is so far limiting the CNB from doing more monetary easing despite the very obvious need for monetary easing – no growth, disinflationary pressures, declining money-velocity and a fairly strong Czech koruna. However, the CNB seems nearly paralyzed. Among other things because the majority of CNB board members seem to think that monetary policy is already easy because interest rates are already very low.

What the majority on the CNB board fail to understand is of course that interest rates are low exactly because the economy is in such a slump. The majority on the CNB board members are guilty of what Milton Friedman called the “interest rate fallacy”.  As Friedman said in 1997:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Looking at the Czech economy makes it pretty clear that monetary policy is not easy. If monetary policy was easy then property prices would not be declining and nominal GDP would not be contracting. If monetary policy was easy then inflation would be rising – it is not.

It therefore obvious that the Czech economy desperately needs monetary easing and since interest rates are already close to zero it is obvious that the CNB needs to use other instruments to ease monetary policy. To me the most obvious and simplest way to ease monetary policy in the present situation would be to use the exchange rate channel. The CNB should simply buy foreign currency to weaken the Czech koruna until a certain nominal target is met – for example bringing back the level of the GDP deflator back to its pre-crisis trend. The best way to do this would be to set a temporary target on Czech koruna against the euro – in a similar fashion as the Swiss central bank has done – until the given nominal target is reached. This is what Lars E. O. Svensson – now deputy governor of the Swedish central bank – has called the foolproof way out of deflation.

CNB governor Miroslav Singer seems to be open to this option. Here is what he said in a recent interview with the Czech business paper Hospodarske Noviny (my translation – with help from Czech friends and Google translate…):

“We talked about it in the central bank’s board about what the central bank can buy and put the money into circulation. What all can lend and – in extreme case – we can simply hand out money to citizens. Something that is sometimes referred to as “throwing money from a helicopter.” If it really was needed, it seems to be the easiest to move the exchange rate. It is logical for the country, which exports the products of eighty per cent of its GDP. If we felt that in our country there is a long deflationary pressures, the obvious way to deal with it is through a weakening currency.”

It should be stressed that I am slightly paraphrasing Singer’s comments, but the meaning is clear – governor Singer full well knows that monetary policy works and I certain agree with him on this issue. Unfortunately my good friend Ludek Niedermayer to some extent disagrees.

Here is Ludek in the same article:

“It would mean leaving a floating exchange rate and our trading partners would be able to complain, that we in this way supports our own exports”

Ludek here seems to argue that the way a weakening of the koruna only works through a “competitiveness channel” – in fact governor Singer seems to have the same view. However, as I have so often argued the primary channel by which a devaluation works is through the impact on domestic demand through increased inflation expectations (or rather less deflationary expectations) and an increase in the money base rather than through the competitiveness channel.

Let’s assume that the CNB tomorrow announced that it would set a new target for EUR/CZK at 30 – versus around 24.90 today (note this is an example and not a forecast). Obviously this would help Czech exports, but much more importantly it would be a signal to Czech households and companies that the CNB will not allow the Czech economy to sink further into a deflationary slump. This would undoubtedly lead households and companies to reduce their cash reserves that they are holding now.

In other words a committed and sizable devaluation to the Czech koruna would lead to a sharp drop in demand for Czech koruna – and for a given money supply this would effectively be aggressive monetary easing. This will push up money-velocity. Furthermore, as the CNB is buying foreign currency it is effectively expanding the money supply. With higher money supply growth and higher velocity nominal GDP will expand and with sticky prices and wages and a large negative output gap this would likely also increase real GDP.

This would be similarly to what happened for example in Poland and Sweden in 2008-9, where a weakening of the zloty and the Swedish krona supported domestic demand. Hence, the relatively strong performance of the Swedish and the Polish economies in 2009-10 were due to strong domestic demand rather than strong exports. Again, the exchange rate channel is not really about competitiveness, but about boosting domestic demand through higher money supply growth and higher velocity.

The good news is that the CNB is not out of ammunition and it is similarly good news that the CNB governor Singer full well knows this. The bad news is that he might not have convinced the majority on the CNB board about this. In that sense the CNB is not different from most central banks in the world – bubble fears dominates while deflationary risks are ignored. Sad, but true.

PS I strongly recommend for anybody who can read Czech – or can use Google translate – to read the entire interview with Miroslav Singer. Governor Singer fully well understands that he is not out of ammunition – that is a refreshing view from a European central banker.

Related posts:

Is monetary easing (devaluation) a hostile act?
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons
Mises was clueless about the effects of devaluation
The luck of the ‘Scandies’
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic
Monetary disorder in Central Europe (and some supply side problems)

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9 Comments

  1. Max

     /  October 16, 2012

    I agree with Ludek. A better approach is to announce a price level (or GDP level) path. This is only a change in the central bank’s target, not a change in the policy instrument, which remains the short term interest rate. And it’s a more foolproof method than exchange rate intervention, since FX intervention requires the cooperation (at least passive cooperation) of the target countries.

    Reply
    • Max, I agree that the CNB needs to announce a clear target, but to have credibility about the target the central bank also have to be completely clear about how to achieve that target. The CNB could also do more traditional QE to achieve a certain target – however, operationally it is much easier to use the exchange rate channel in the conduct of QE to achieve a given target.

      Reply
      • Max

         /  October 16, 2012

        If the CB’s target is achievable using the interest rate instrument (i.e. doesn’t require a <0% rate), why would it need to experiment with market interventions?

  2. Max, I fundamentally think that a target in itself is not enough when you start out with a situation where you have no credibility. You only establish credibility by demonstrating you mean business.

    Reply
  3. Benjamin Cole

     /  October 19, 2012

    Excellent blogging. I nearly stopped reading after you wrote the Czech central bank was keeping the inflation rate at zero.

    That’s all you need to know. If ever a central bank target the central bank nirvana of zero inflation, the economy is asphyxiated.

    More and more, I am wondering if central bank independence is advisable. We are talking about a public institution in a democracy, and perhaps the most important institution for the economy. And citizens have to keep hands off?

    Democracy requires transparency and accountability of public institutions. Yes, the public may make policy mistakes. But I sense the public would be a great barometer of what a central bank should do. If they are pursuing central bankerly pipe dreams of zero inflation, and people are unemployed, I sense they will be voted out.

    Scott Sumner also raises an interesting point about Europe: Say you are a citizen in France and you are disgusted with ECB policy. How do you vote that disgust?

    Insulating public agencies from voter discontent never turns out well. All public agencies want to be above review, and to be opaque, and mysterious if possible.

    Central banks also.

    Reply
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