If we look around the world, there has been very few monetary policy success stories from 2008 and onwards. However, there is a success story that unfortunately largely has been untold and that is the success of monetary policy in the Czech Republic after November 2013 when the Czech central bank (CNB) decided to fundamentally change its operational approach to the conduct of monetary policy.
Until late 2013, the CNB in many ways had failed. Effectively, interest rates had hit the Zero Lower Bound (ZLB) and the CNB clearly was reluctant to use other instruments to ease monetary policy despite of the fact that inflation consistently since crisis hit in 2008 had been below the CNB's 2% inflation target and that there clearly was significant slack in the Czech economy.
At the same time, nominal GDP had essentially been flat from 2008 until late 2013 and deflation expectations clearly were growing.
However, during 2012-13, a number of CNB board members started to hint that there was a way - indeed many ways - to see monetary policy even with interest rates stuck at zero. During this period - in fact starting around 2010 - I had been arguing - both in my position at that time as Head of Emerging Markets Research at Danske Bank and on my blog that the CNB could use the exchange rate as an instrument to implement monetary easing to hit the 2% inflation target.
More specifically, I argued that the CNB could put a "floor" under EUR/CZK in the same way the Swiss central bank had done with the Swiss franc. In non-technical terms, this mean that the CNB should cap any appreciation of the Czech koruna against the euro, but allow for depreciation.
In December 2012, I wrote:
The short version of this is: The Czech economy is in a deflationary trap so the CNB needs to ease monetary policy, but with interest rates basically at zero the CNB needs to use the exchange rate to do this. This basically leaves the CNB with two options.
Either to follow the lead from the Swiss bank bank and put a floor under EUR/CZK or to implement a Singaporean style monetary regime, where the central bank starts using the exchange rate (and communication about future depreciation/appreciation) as the primary monetary policy instrument rather than interest rates.
November 2013 - the floor is announced
Whether or not the CNB listened to me, I don't know, but on November 7 2013, the CNB announced the following:
The Board also decided to start using the exchange rate as an additional instrument for easing the monetary conditions. The CNB will intervene on the FX market to weaken the koruna so that the exchange rate of the koruna against the euro is close to CZK 27/EUR.
This effectively was a 4% devaluation of the koruna and a commitment to curb any appreciation pressures as long as Czech inflation was below the CNB's 2% inflation target.
Needless to say, I was extremely happy with the decision and in a blog post commenting on the decision, I wrote among other things the following:
…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.
…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.
A smashing success
The development in the Czech economy over the past nearly three years in my view provides a test of Market Monetarist thinking. Hence, MM-thinking led me to argue that there was no liquidity trap and that what the CNB's announcement would work in the sense it would increase nominal spending growth (NGDP growth) and hence curb deflationary pressures.
So how did it in fact go?
Let's first have a look at the favourite Market Monetarist indicators - Nominal GDP.
It is pretty hard to miss - before November 2013 NGDP was basically flatlining, but exactly as the "floor" under EUR/CZK was announced NGDP growth took off and within a few quarters had accelerated to just above 5% and NGDP growth has ever since grown steady along a 5% path.
Given the fact that potential real GDP growth in the Czech Republic in my view probably is close to 3%, this means that 5% nominal GDP over the cycle will ensure inflation around 2%. Or said in another way - CNB has since November 2013 has got it absolutely right!
But how about inflation?
If we look at the GDP deflator as our measure of inflation, then the picture is more or less the same as for nominal GDP even though inflation had started to pick up already in 2012, but after November 2013, GDP-deflator-inflation for the first time since 2009 rose above 2%, and even though inflation has eased somewhat over the past year, we have not returned to deflation and with the continued healthy growth rate of NGDP, inflation is likely to remain fairly close to 2% going forward.
So it is certainly mission accomplished in nominal terms for the CNB - nominal GDP growth has been stable and GDP deflator has been on a 2% growth path, but what about the real-side of things?
Obviously, monetary policy cannot impact real variables such as real GDP growth and unemployment over the long run, but if monetary policy is too tight, it will in the short-run - which can turn out to be a fairly long period - lead to a slump in the economy and increased unemployment. This of course is exactly what happened in the period from 2008 to November 2013 as the graph below clearly shows.
However, the graph also shows that the monetary easing implement after November 2013 has helped push unemployment down significantly in the Czech Republic. Hence, there is no doubt that monetary easing has had a real and large impact in the Czech economy.
Monetary policy is highly potent also at the ZLB
The discussion above in my view clearly shows that there is no "liquidity trap" and that central banks always can ease monetary policy also when interest rates effectively are at the Zero Lower Bound if just central bankers commit themselves to do it as the CNB so forcefully has demonstrated over the past nearly three years.
So once again, it is clear that monetary policy in the Czech Republic has been a smashing success over the past three years, and CNB governor Miroslav Singer - who stepped down as CNB governor after six years earlier this month - deserves a lot of praise for this policy.
The policy implemented under Singer's leadership clearly has been hugely positive for the development in the Czech economy over the past three years. However, I think it is equally important to stress that other countries easily could follow CNB's example or as I wrote in November 2008:
… 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.
I hope other central bankers around the world will be listening.
P.S. The CNB's board recently said it plans to maintain the EUR/CZK floor at 27, but expect it to be discontinued mid-2017. Given the fact the Czech NGDP growth has slowed a bit below 5% in recent quarters and that the European economy once again looks fragile and global deflationary pressures remain strong, I think the signal of discontinuing the floor is slightly premature. That said, I don't think it would cause a major monetary tightening given the fact that the "fair value" for EUR/CZK probably is fairly close to 27.
P.P.S. CNB still could do a lot of things better. See for example my suggestions from November 2013 or the suggestions I made for the SNB in January 2015. The advice for the SNB also would apply for the CNB.