Yesterday the global market focus not surprisingly mostly was on the ECB’s surprise 25bp refi rate cut. However, from a monetary policy perspective something a lot more interesting happened in the Czech Republic. Hence, yesterday in connection with its monthly board meeting the Czech central bank (CNB) made the following statement:
The CNB Bank Board decided at its meeting today to keep interest rates unchanged. The two-week repo rate was maintained at 0.05%, the discount rate at 0.05% and the Lombard rate at 0.25%.
The Bank Board also decided to start using the exchange rate as an additional instrument for easing the monetary conditions. The CNB will intervene on the foreign exchange market to weaken the koruna so that the exchange rate of the koruna against the euro is close to CZK 27.
Shortly after the CNB made the announcement the central bank intervened directly in the currency market to weaken the koruna. The net result has been that the koruna has weakened around 4% in reaction to the policy announcement. This is probably the most important monetary policy decision in post-communist Czech monetary history.
I have long argued that the CNB should do exactly this. For years the Czech economy has been caught in an quasi-deflationary trap and the CNB has so far been mentally and institutionally unable to ease monetary policy as the CNB has been stuck at the Zero Lower Bound. However, anybody who reads my blog and other Market Monetarists blogs should know that central banks can always ease monetary policy – also when interest rates are close to zero. Said in another way there might be a Zero Lower Bound, but there is no liquidity trap.
Essentially the CNB is now doing exactly what the Swiss central bank successfully has done to curb deflationary pressures in the Swiss economy over the last couple of years. It has worked in Switzerland and I feel very confident it will work in the Czech Republic if the CNB remain committed to the announce policy. CNB governor Miroslav Singer certainly deserves a lot of praise for this bold move. It has taken him far too long, but he finally got it right in the end. In fact Singer has long wanted to do this – but it has taken some time to convince the majority of CNB board member that this was the right thing to do.
Overall, one can say that Singer is following the advice from Bennett McCallum who in a number of papers over the years have suggested that central banks can use the exchange rate as the key monetary policy instrument when interest rates are at stuck at zero. For my earlier discussion of McCallum’s work see here.
Watch domestic demand!
Many commentators have already commented that the CNB’s actions has the purpose to boost growth by boosting exports. The argument is that a weaker koruna will improve Czech competitiveness and hence boost Czech exports. It is surely right that a weaker koruna is likely to help Czech exports, but I think it will much more important what this will increase growth and inflation expectations, which is likely to boost domestic demand and I believe this will be much more important for the coming Czech recovery that any pick-up in exports.
While I believe that the CNB’s FX intervention will boost money base growth in the Czech Republic and likely also broader money supply growth I believe that most of the monetary stimuli is likely to come from an increase in money-velocity. Hence, if households, financial institutions and corporations expect growth and inflation to pick up then they will reduce their cash holdings. This effectively is lower money demand, which is an pick up in money-velocity.
So the interesting thing to watch coming months will not be Czech exports, but rather money-velocity and domestic demand.
Now it is time to work on communication Miroslav
I think the CNB under the leadership of Miroslav Singer yesterday took a major step to get the Czech economy out of the quasi-deflationary trap. However, more needs to be done.
First of all I think that the “devaluation” was too small. I would have preferred a “target” of 30 for EUR/CZK rather than 27. So yes, this will work, but I am not sure it is enough.
Second, Miroslav Singer needs to convince investors and Czech consumers that he is serious about this. Effectively he needs to spell out his reaction function. Preferably he needs to become a bit more clear on what he wants to achieve and even more importantly he needs to make it 100% clear that if inflation and growth does not pick up fast enough then he will act to weaken the koruna even more. It is all about forward guidance.
If Singer gets his forward guidance right then I don’t think he needs to do much more actual FX intervention. Hence, if the markets know that he will step up FX intervention (effectively QE) in the event that the growth and inflation pick-up is not strong enough then the markets will do most of the lifting – the koruna will simply start weakening without FX intervention. This is of course the Chuck Norris effect in full action. Therefore, I believe that Singer should use any excuse – for example one or two weak macroeconomic numbers – to tell the markets he could do more FX intervention if needed.
Furthermore, he should very clearly tell the markets that EUR/CZK will not be allowed to drop below 27 and that he could at anytime increase the EUR/CZK “floor” if needed.
Singer yesterday correctly reminded everybody that there is no limits to the amount of FX intervention he can do to weaken the currency. He and only he can print Czech koruna. So if Singer is serious about this – and I believe he is – you would have to be very stupid to try to bet on the Czech koruna to strengthen before Singer’s has successfully hit his policy objectives.
The CNB is doing everybody a favour
Obviously yesterday’s rate cut from the ECB was a bigger market event and news story than CNB’s bold actions. However, from a perspective of understanding monetary policy everybody should really focus on what the CNB did. I strongly believe that Miroslav Singer has delivered the kind of policy action needed to get the Czech economy out of the crisis and every central banker in the world should have a look at the CNB’s action. I am sure Singer would be happy to welcome central bankers from around the world to visit him in the beautiful city of Prague.
I am still extremely nervous that we are heading for years of deflation in the euro zone, but I also believe that Miroslav Singer is now demonstrating to his colleagues in the ECB that it is possible to ease monetary policy is at the Zero Lower Bound (the ECB is not even at the ZLB!). In that sense Singer is doing everybody a huge favour by demonstrating this.
Hence, yesterday’s actions from the CNB is not only good news for the Czech economy, but it is hopefully also a lesson for central bankers around the world. Good work Miroslav!
Update: The CNB has a very good FAQ on the currency as a policy instrument – see here (I only disagree on one point – guess which one). The CNB is getting the communication right – so I guess CNB Head of Communication Marek Petrus deserves some praise as well.