Is the CNB's latest decision an effective response to rising prices? Central bankers are not very convincing

“Is the CNB's latest decision an effective response to rising prices? Central bankers are not very convincing,” expresses Miroslav Singer, Chief Economist at Generali CEE Holding and former governor of the Czech National Bank in his article for one of the major economic dailies in the Czech Republic, Hospodářské noviny. You can find the original article in Czech language HERE.

The new Banking Board of the Czech National Bank (CNB) adopted the expected, but highly criticized by most commentators, decision not to change interest rates despite the increase in inflation expectations. Behind this decision is apparently the belief, or perhaps at least the hope of the five members of the Board, who voted for this decision, that inflationary pressures will subside next year and that the wave of inflation can be "survived while waiting". The basic arguments for this decision are given by a less valuable model of the economy compared to "more normal times", which indicates that if the normally targeted inflation period is stretched from 4-6 quarters to 6-8 quarters, inflation will be only slightly above 2% in the newly defined target period.

This argument was obviously important in the decision. According to the CNB's analysis, the extension of the targeted horizon immediately reduces rates by approximately five percentage points. But it is relatively easy to question. Perhaps it would be wiser to more explicitly acknowledge the need to wait for the next rate change. It is quite understandable that in uncertain times one can simply stop for once after a period of sharp rate increases. Perhaps also to make it easier to see how the uncertainties that will affect our economy (and therefore the rise in prices in it) are developing. For example, the global conjuncture, world prices of raw materials, etc.

Each extension of the horizon mainly reduces the forecast quality of the CNB model for the period in which inflation is targeted. The existing model, the development of which I had the opportunity to experience together with the experts of the currency section, predicts worse on its distant horizon. And not only because the future is always less certain. Very simply, and I hope it is understandable, the statistical model of the CNB, in order to be computable at all, must assume that in the longer term the Czech economy will always return to its long-term, equilibrium values. So also the fact that if we wait long enough, inflation will return to the two percent target. If we shift the horizon at which we are aiming, the model prediction always results in a smaller need for today's intervention. The predicted inflation values will simply get closer and closer to two percent in the model. It is indeed extremely difficult to distinguish this shift from the behavior of an economy that will hopefully absorb an inflationary shock in the future without further chaining.

By the way, in more demanding times, this feature of the model always complicates and has complicated the communication of the central bank. After the decision to use the weakening of the exchange rate to avert deflationary development, we heard many times with a painful feeling from (pretending to be enlightened rather than actually being enlightened) commentators that "this step was unnecessary, because even the CNB model indicated that inflation would quickly return to positive levels numbers close to the target”. No, indeed, the argument in the forecast was not a visible return of inflation from negative values to the target. The model used by the CNB, as well as the models of most central banks, simply do not allow modelling a development in which the economy starts moving away from its equilibrium values or inflation target in the long term. Therefore, even longer-term inflationary or deflationary spirals are not suitable for risk analysis.

Which is related to the second risk – in order for inflation to return somewhere to the target in 2024, it is necessary that inflationary expectations and the related behavior of consumers, employees and producers do not detach from the CNB's two percent target in the long term. If we return again to the published presentation of the central bank for analysts, we find that it discusses, among other things, an alternative scenario in which inflation expectations (and the associated behavior in determining product prices, wage negotiations, etc.) will shift to five percent by the end of next year to then return to two percent. The risks of such disengagement are threatening for inflation to return to the target, and exchange rates must go up to four percentage points higher in this scenario than with expectations stabilized at two percent.

It is questionable whether it is really possible to assume that inflation expectations will remain stable and anchored at two percent at a time when the CNB's own forecast expects inflation of around 20 percent this year and nearly ten percent next year. It is therefore also good that the representatives of the central bank emphasized after their decision on Thursday that all indications of, for example, wage developments (it is certainly worth following the development of producers' margins in more detail) will be taken very seriously.

From the point of view of fulfilling the mandate of the central bank, and in the statement of the bank board's stated determination to fulfil it, it is worth reminding that the CNB can and should take into account its other goals, such as financial stability or the promotion of economic growth, only if this does not call into question with its main goal, i.e. price stability. However, the latest decision is based on data and predictions, from which it follows, among other things, that the central bank reacts to higher inflation and a higher forecast of price growth with monetary policy, which, at least from the point of view of already published forecasts of the development of the labor market, hardly means tightening. Specifically, compared to previous forecasts, higher wage growth, albeit accompanied by slower employment growth and similar unemployment, hardly signals that the current decision will be an effective response to accelerating price growth. It is not certain that it will lead to a reduction in demand impulses pushing prices up.

The decision to keep rates at the current level is understandable in light of the uncertainties in the development of the world economy. However, extending the horizon in which the central bank decides to target inflation is an argument that cannot help its defenders in the long term. And it is somewhat difficult to communicate using the forecast generated by the current model to illustrate that rates may not rise any further. After all, I personally expect that, as has always happened after a more substantial change in the composition of the Bank Board, this time too there will be a debate in our central bank about the relationship, if you will, of the "ownership" of the forecast of the currency section generated primarily by the model served by it and the Bank Board.

And I also pray that, as the current forecast predicts, the increase in prices will not eventually be chained further by the further reaction of employees and manufacturers, and the development predicted for 2024 will therefore come true. Or that the signals that this is not happening are at least recognized in time and monetary policy reacts to them adequately and quickly in the future.

(Source: Hospodářské Noviny daily, 9.8. 2022)