Aleš Michl: The road to the target II
Speech by Mr Aleš Michl, Governor of the Czech National Bank, at the Czech Banking
Association (CBA) Assembly of Members, Prague, 15 June 2023.
* * *
President,
Members of the Czech Banking Association,
Thank you very much for inviting me to speak at the banking association's annual
assembly. Your work follows up on that of the Union of Czech Banks (and later the
Union of Czechoslovak Banks), which was established in 1917. The Union not only
defended the interests of Czech banking, but also contributed significantly to the
survival and subsequent development of the new republic.
The then senior managers of Czechoslovak banks and chairmen of the Union were
Jaroslav Preiss, Managing Director of Živnostenská banka, and Karel Svoboda,
Managing Director of Agrární banka (Kunert, 2017). They collaborated with leading
Czechoslovak economists like Alois Rašín and Karel Engliš. Together they made a
substantial contribution to the creation and success of Czechoslovak banking and thus
to the economy of the time.
Even if they disagreed with some of the financial or monetary measures, their priority
1
was, in their own words, "to work objectively for the nation and the state" , meaning
their priority was not only to defend their own interests, but to defend the interests of the
state. Let's bear that in mind in our work today - we are not here to promote our own
interests, but to promote the interests of the republic. But what does that actually
mean? For example, it means that you, the banks, should now raise interest rates on all
household deposits, even short-term ones, and share a somewhat larger proportion of
your profits with your clients (Michl, 2019a). Let's base our economy on savings, not on
debt.
A month ago I made a speech at the University of Economics and Business in Prague
(Michl, 2023). I would like to follow up on the speech here, recap its main ideas and
expand on them in the context of new data on the economy.
I started the speech at the University of Economics and Business by saying that I had
good news for the public: inflation is finally falling. This is being confirmed. Annual
headline inflation peaked in September last year, when it reached 18%. We managed to
stop it. In line with our expectations, a gradual downward trend in inflation started in
February this year. Inflation fell to 16.7% in February and then to 15%. In April, it stood
at 12.7%. The inflation figure for May (11.1%) was published on Monday this week. It
should fall to below 10% in annual terms within two months.
This is not a victory.
In the second half of the year, inflation will still be at a level we must not put up with. We
must not get used to it. We must not adapt to it. Interest rates will therefore remain high
for longer. For the time being, there is no point speculating on when interest rates will
be cut. On the contrary, as you know from the voting we published, some Bank Board
members are still thinking about raising rates further - our monetary policy meeting is
next Wednesday.
A strong koruna played an important role in the turnaround in inflation. We adjusted the
monetary policy strategy in July 2022. We stabilised interest rates and verbally
supported a strong koruna. In a speech at Masaryk University in November 2022, I
presented the conditions under which our koruna would be strong again (Michl, 2022).
Although we did not raise the CNB's repo rate further to more than 7%, we managed to
have a record-strong currency. The average monthly exchange rate of the koruna to the
euro was the strongest ever in April 2023, reaching CZK 23.44 to the euro (for
comparison, it was CZK 23.55 to the euro in July 2008). I will always be proud if we
have a strong koruna during my mandate.
In 2023 Q1, the strongest-ever koruna together with the highest interest rates since
1999 created the tightest monetary conditions in more than twenty years (a more
detailed analysis is available in our blog post published on the CNB website, see Adam
and Michl, 2023). The strong exchange rate made imports cheaper and tightened
monetary conditions also for exporters. The large ones in particular had not been
influenced by our monetary policy too much until then, since they were taking out loans
in euros.
So far we have only succeeded in the first phase.
There are still two more phases in the fight against inflation: In the second phase,
inflation needs to fall to below 10% in the second half of this year, in line with our
forecast. And then, in the third phase, inflation needs to continue to fall to levels close to
2% next year, which will be the best news for the economy.
More than before, the new Bank Board is monitoring and discussing money flows in the
economy, and above all loans to households, firms and the government. We must look
at money. We conduct monetary policy. The term is derived from the word "money",
which we label as M1 and define as the quantity of money in the economy. We have
added elements of monetarism to New Keynesian economics, the predominant school
of thought at the CNB so far.
For illustration, broad money (M3) has risen by 31% since January 2020 (pre-Covid).
The price level has increased by 33% in the same period.
In order to significantly slow inflation, money growth must also be slowed substantially.
Our DSGE model created according to the New Keynesian theory ends with the
threemonth PRIBOR interest rate (Michl, 2019b). On top of that, in our considerations, the
Bank Board must discuss the evolution of longer client interest rates and take into
account how the interest rate transmission mechanism works and how changes in
shortterm rates will affect long-term rates. We attribute a greater role to credit in the
economy and debt, which our model previously left out. Deputy Governor Eva
Zamrazilová also spoke about this at the University of Economics and Business. Deputy
Governor Jan Frait also discussed this topic in his lecture at the university in Ostrava in
2023. Credit market developments very well combine our two main objectives - price
and financial stability.
Because of the transmission lag, the central bank should correctly stop raising rates
before inflation peaks. The problem of this academically and practically correct
approach is that people can see that inflation is still high and might think that the central
bank is not determined to fight inflation because rates have stopped rising. So, I try to
explain over and over again that the CNB's interest rates are already at a level that is
dampening economic activity. We have the tightest monetary policy in more than twenty
years and we want it to remain so for some time.
The current data from money flow monitoring are as follows:
The volume of new mortgages fell by 64% year on year in January-April 2023.
New koruna loans to firms fell by 54% year on year in the same period.
However, firms are fleeing to the euro - 47% of new loans to firms are currently in
euros. Nevertheless, this channel is also gradually cooling as the ECB raises its rates.
The volume of new euro loans to firms fell by 16% in January-April.
The decline in demand in the economy is documented by the following indicators:
Household consumption, which is crucial for the future course of demand-pull inflation,
fell for the sixth consecutive quarter and is below the pre-Covid level.
The saving rate is now 21.7% (data for 2022 Q4), while the long-term average is 12%.
The decline in demand is also illustrated by the fact that prices of new apartments are
already falling quarter on quarter.
I want to emphasise that there is no wage spiral in the economy. The average nominal
wage rose by 8.6% year on year in Q1. Nominal wages increased half a percentage
point more slowly than expected in our May forecast, which expects inflation to return to
the target in the first half of next year. The average real wage fell by 6.7%, decreasing
for the sixth consecutive month.
For comparison, the average wage at the CNB used to be linked to inflation. However,
we managed to renegotiate this with the trade unions, and the average wage at the
central bank rose by 4.5% this year. We are thus setting an example, not least by
showing that inflation clauses can often be changed by agreement of the two parties.
These are steps that can be taken to avoid a wage spiral.
The decline in real demand means that the economy is below potential output and we
have a negative output gap. Interest rates are slowing growth in the quantity of money
in the economy. Inflation pressures are fading as a result.
In the speech at the University of Economics and Business, I also mentioned two
problems that are and will continue to be relevant: (1) the CNB's large balance sheet
and (2) government debt.
Regarding the CNB's large balance sheet, over the last ten years, interest rates were
too low, in fact zero for a long time. In addition, in early 2017, interventions led to an
increase in the CNB's balance sheet within four months, or rather in the banking
sector's liquidity. It increased from CZK 1,300 billion in December 2016 to CZK 2,300
billion in April 2017, i.e. there was an additional CZK 1,000 billion in the balance sheet,
or an almost doubling of the balance sheet within four months of 2017.
During these interventions, demand for Czech government bonds from non-residents
increased. This further expanded the country's borrowing options. Budget constraints
were eased. Then, during Covid, in particular at the end of March 2020, interest rates
were reduced too close to zero. And fiscal policy was expansive for too long - we
created a dangerous entitlement economy in which the state was the rich uncle who
helped with almost everything. When an economy such as this one (especially one with
a huge surplus of money and incomplete price convergence) was hit by a strong cost
shock after the lockdowns, the Czech Republic ended up with the highest core inflation
in the EU (from November 2021 to October 2022). We address the causes of inflation in
the Czech Republic in our blog article (Adam and Michl, 2022).
The central bank's large balance sheet can lead to changes in monetary policy
transmission. This is also because when key interest rates are raised, monetary
policymaking expenses increase. We pay interest to members of the Czech Banking
Association, i.e. commercial banks, for their excess liquidity deposits. To give you an
idea, the CNB paid CZK 15.3 billion to the banks in interest on deposited liquidity in
May 2023, which may amount to CZK 185 billion for 2023 as a whole. This can lead to
a change in the behaviour of banks, i.e. how and to whom they provide loans, by how
much they raise deposit rates. In a system with excess liquidity, banks easily buy
government bonds and government debt is monetised.
An important lesson for me is that we will try not to repeat 2017 at the CNB and conduct
monetary policy in a conventional manner. In his article, "Less is more" for the IMF's
magazine, Professor at the University of Chicago and former Governor of the Reserve
Bank of India Raghuram Rajan said: "Central banks have constrained their own policy
space with asymmetric and unconventional policies, ostensibly intended to deal with the
policy rate touching the lower bound. They have triggered a variety of imbalances that
are making fighting inflation harder today." More purposeful and less interventionist
central banks would probably do better than a high-inflation, high-debt, low-growth
world (Rajan, 2023).
For central banks, less can mean more. Therefore, our strategy in the Czech Republic
is "higher for longer", i.e. to maintain interest rates at higher levels for longer.
Regarding government debt, I stated that monetary policy is at its tightest in 20 years
and is slowing the economy. A problem arises if the government helps the economy
with subsidies, supports and contributions at the same time. This counters our fight
against inflation and the economy is not dampened as much as it should be. Therefore,
the CNB must consider the following: Should we start competing with the government
and dampen the economy by, for example, increasing rates? Should we further push
down demand, just to have it subsequently fostered by the government with some kind
of supports or subsidies? And so on ... it is a vicious circle. It would be better if both
policies were anti-inflationary at the same time. Cochrane (2003) describes these
considerations, as does the excellent article on the subject presented by Bianchi and
Melosi (2022) at the conference in Jackson Hole last year.
To add to that, everything is complicated further by the first problem described above, i.
e. the CNB's large balance sheet, or the huge liquidity of the banking sector. I agree
with Professors Mandel and Dvoák (2022) from the University of Economics and
Business who stated in their article "Current global inflation" that Milton Friedman's view
that restrictive monetary policy is not dependent on the support of fiscal policy and can
be effective in its own right was formulated for a situation where there was an
appropriate amount of bank liquidity. In a monetary system with huge excess liquidity
and induced high inflation, a reduction in the state budget deficit plays a key role in the
fight against inflation and significantly eases the position of the central bank.
Therefore, defeating inflation in the long term is conditional on coordination between
monetary and fiscal policy. If fiscal policy records increasing budget deficits, monetary
policy will find it very hard to ensure low inflation on its own, in a system with such a
huge liquidity surplus and a willingness of banks to buy bonds. That is why I said at the
press conference after each of our monetary policy meetings that reducing the country's
debt is a further key condition for lowering inflation.
It is essential in the fight against inflation that the state budget deficit falls as much as
possible compared with the actual outcome of the previous year. It would be ideal for
the fight against inflation if expenditure declined year on year compared with the actual
outcome of the previous year (to dampen demand) and indirect taxes were not
increased (to avoid increasing inflation). However, that is a political decision and it is not
within my competence. In any case, we need our tightest monetary policy in twenty
years to be accompanied by a credible budget consolidation plan, which the public will
trust to support our efforts to reduce inflation.
Inflation is our responsibility. However, we are in this together with the government. We
need support from fiscal policy and from you. Reducing inflation is in the country's
interest. We have already tamed several money flows in the economy. Above all,
reducing the country's debt is now needed for a long-lasting return of inflation to low
levels. However, banks should also raise interest paid on all household deposits and
motivate people to save even more. And this is what we should fight for together. For
less debt and more savings. In the interest of the republic.
References
Adam, T. and Michl, A. (2022). Inflace v R:cyklický i acyklický píbh? [Inflation in the
Czech Republic: A cyclical or acyclical story?] (cnBlog - official blog of the Czech
National Bank).
Adam, T. and Michl, A. (2023). Inflace klesá - prbžné vyhodnocení dezinflaního
procesu v esku [Inflation is falling - an interim assessment of the disinflation process in
the Czech Republic] (cnBlog - official blog of the Czech National Bank).
Bianchi, F. and Melosi, L. (2022). Inflation as a Fiscal Limit (external link) . (FRB of
Chicago Working Paper No. 2022-37).
Cochrane, J. H. (2023). The Fiscal Theory of the Price Level. Princeton University
Press. ISBN: 9780691242248.
Frait, J. (2023, 17 March). Monetary Macroeconomics and Central Banks in Turbulent
Times [lecture transcript]. Czech National Bank.
Kunert, J. (2017). eské banky musí býti konen oporou a prkopníkem eského vývoje
hospodáského. [Czech banks must finally be the backbone and pioneers of Czech
economic development] Bankovnictví 2017, No. 8, 10-15.
Mandel, M. and Dvoák, P. (2021). Co nás eká s rostoucím státním dluhem? [What
awaits us with rising government debt?] Bankovnictví 2021, No. 6, 38-41. ISSN 1212
4273.
Michl, A. (2019a). Banky by mly zvednout úroky u vklad [Banks should raise interest on
deposits]. Mladá fronta DNES, 17 January 2019, p. 11, Interview section.
Michl, A. (2019b). Ten years later: Lessons for DSGE builders and Czech policy makers
(external link) . Review of Economic Perspectives, 19(3) , 159-174.
Michl, A. (2022, 23 October). Governor's opening remarks at the CNB Discussion Forum
[Audiovisual recording]. Czech National Bank.
Michl, A. (2023). The road to the target. Discussion on "Inflation: The road to the target"
University of Economics and Business, Prague, 15 May 2023.
Rajan, R. (2023). Less is more (external link) . Finance and Development Magazine,
March 2023
, 11-14.
1
CNB Archive, Živnostenská banka archive, ŽB/1777/3, Minutes of the Board of
Directors' meeting of 14 March 1934, Report by Dr. Jaroslav Preiss for the Board of
Directors' meeting, p. 3, cat. no. 1777.