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23. 4. 2024 I Michl Ales

The target

Ales Michl, CNB Governor
CNB Discussion Forum 2024
University of Pardubice
Pardubice, 23 April 2024

I will start with mathematics and physics, specifically celestial mechanics, the science of the
motion of celestial bodies. One of the tasks of celestial mechanics is to calculate and predict the
motion of three bodies that interact gravitationally, for example, the sun, the earth and the moon.
To this day, it's still a difficult mathematical and physical problem to solve. Under certain
assumptions, such as one body having negligible mass compared to the others, the problem
can be solved. The issue is explored in popular form in The Three-Body Problem by Chinese
science fiction author Liu Cixin.

In the economy, we also have three bodies: the private market, the government and the central
bank. However, modelling the relationships between them and predicting future developments is
an even harder task than three-body motion in physics. It requires many simplifications and
assumptions. Unlike in physics, there are no hard and fast laws such as the law of gravity or the
law of action and reaction.

Economic predictions sometimes don't work out. After all, even the knowledge of economists
isn't as constant as that of physicists. Streams of economics are sometimes very wide of the
mark.

In the first half of 2022, prices in the Czech Republic grew at the fastest rate in history, leaving
aside the transformation period. The annual inflation rate was a terrifying 18% in September
2022.

The whole world was hit by rising costs, especially rising energy prices. However, the Czech
Republic had the highest inflation in the European Union at the time, even adjusted for this cost
shock ("core inflation"). Some specific and unique errors must therefore have been made in our
country in the past.

eS main monetary policy errors were:

(1) Incorrect and late termination of the Czech koruna depreciation policy in late 2016 and early
2017. At that time, speculation on the koruna led to excessive growth in bank money. The
liquidity excess in the banking sector almost doubled from CZK 1.3 trillion to CZK 2.4 trillion
between December 2016 and March 2017.

(2) The second error was that the CNB's key interest rates had been below inflation for the
previous more than ten years. In other words, real interest rates had been negative. For
example, in 2010-2022, when average annual inflation was 3%, the average CNB repo rate was
1% and the average ex ante real rate -1.4%. That is not an anti-inflationary policy. It can hardly
be made up for by sudden and rapid rate hikes once inflation has set in.

Inflation and interest rates in 2010-2022

. Average annual Average CNB repo Average ex-post realrepo Average ex ante real
Period . .
inflation (%) rate (%) rate (%) rate (%)
2010-
14 0.3 -1.0 -1.7

2016

2016- 4.3 1.5 -2.8 -1.1

2022

2010- 3.0 1.0 2.0 14

2022 : , , ,

Source: CNB ARAD
Note: Ex post real rate = repo rate - annual inflation
Ex ante real rate = repo rate - financial market inflation expectations 12 months ahead

Errors (1) and (2) both encouraged borrowing, not saving. In other words, they helped induce
inflation.

In this situation, with inflation at 17.5%, the new Bank Board took responsibility for monetary
policy.

I was appointed Governor in May 2022 with effect from July 2022. In the speech I gave on my
appointment, I said that the goal would be to gradually return inflation to 2% and that I expected
this to take two years (Michl, 2022a).

The new Bank Board took over the management of the bank in July 2022. It was vital for us to
tackle the situation head-on, start solving the problems and deliver results as quickly as
possible.

In a speech at Masaryk University in November 2022, I unveiled a new monetary strategy
setting out the conditions under which the Czech koruna would be strong again (Michl, 2022b).

In February 2023, two new members joined the Bank Board.

In spring 2023, we achieved the tightest monetary conditions in 20 years (the monetary
conditions represent the combined effect of interest rates and the exchange rate on the
economy). The exchange rate of the koruna was the strongest ever at the time, so the country
was able to import expensive commodities more cheaply. The strong koruna also tightened
monetary conditions for large firms, which until then had not been affected by the CNB's high
rates, since they were borrowing in euros. Although the nominal rate stayed at 7% for most of
2023, ex ante real interest rates - which reflect expected inflation - gradually rose to historical
highs. Only then did monetary policy start to work the most.

I have regularly described the path to the target in several speeches over the past almost two
years: the first, already mentioned, at Masaryk University on the strong koruna policy, the
second at the University of Economics and Business, the next at a meeting of the Czech
Banking Association, and the most recent at the university in Zlin (Michl, 2022b; Michl, 2023a;
Michl, 2023b; Michl 2023c).

Annual inflation reached 2% in February and March this year, which is exactly our target. The
last time inflation was at the target was five years ago, in December 2018. We have restored
price stability, our statutory mandate. When I was appointed governor, I said we would deliver
low inflation within two years, and we have. The word of the head of an institution must be
credible and must be kept.

There was no celebration, no special news conference or the like, because the future will judge
us not by partial successes but by the long-term results of our work.

To avoid repeating the mistakes of the past, we will improve the operation of our institution.

In particular, we will stay hawkish and do our utmost to achieve price stability and not cause
inflation. We therefore expect rates to be higher than we have been used to over the last ten
years or more. The economy needs to be based on savings, not debt. That is why I think we
must persist with tight monetary policy. It is possible that in a week's time, when we have a
monetary policy meeting, we will lower rates even further. Even then, however, we will be very
cautious about cutting rates further. We will assess the new data from meeting to meeting and
decide accordingly. The interest rate reduction process can be paused or terminated at any time
at levels that are still restrictive if inflation - especially its core component - does not develop in
line with the forecast.

We take the lessons of past mistakes seriously. We have therefore commissioned a set of
assessments of the conduct of monetary policy. In particular, we expect this review to help

improve our forecasts and modelling of the three-body interaction problem. This is the first
external assessment of monetary policy in the history of the CNB.

The review will consist of three independent parts. A team led by Professor Martin Mandel and
Associate Professor Karel Bruna from the University of Economics and Business in Prague will
look at the broadest range of topics, including the interaction between central bank monetary
policy and government fiscal policy. John Muellbauer from the University of Oxford will evaluate
the set of models used at the CNB and how their outputs are translated into monetary policy
recommendations. Roman Sustek from Queen Mary University of London will focus on the
individual models, their settings and their interactions.

We will evaluate the results of the assessments in the Bank Board and publish the conclusions
around the turn of the year.

In addition to restoring price stability in our country, which is our primary objective, we at the
CNB have also focused on the institution's operations. You remember the first mistake I
mentioned - the late and incorrect termination of the koruna depreciation policy in late 2016 and
early 2017. This increased the CNB's balance sheet and therefore multiplied the volatility of the
bank's financial result. And so the new Bank Board took over the CNB when it had its largest
ever loss: CZK 487 billion.

For the institution to function properly, the new Bank Board had to start with the profit and loss
account. We began with operations, one of the parts of the profit and loss account that could be
addressed immediately. We inherited record-high growth in our operating expenses and we had
to tame it, as the CNB should lead by example. We therefore started a rationalisation in 2023.
Alois RaSin would have been pleased with the results: during 2023 we downsized our senior
management team - managers reporting directly to the Bank Board (BR-1s) - from 17 to 14. As
well as delivering cost savings, this made the institution more manageable.

Results of the rationalisation at the CNB in 2023

2022 2023 Y-o-y change

No. of job positions at the CNB 1,516 1,439 -5.1%
Number of executive directors reporting to the Board 17 14 -18%
Source: CNB

There are now 14 BR-1s under the seven board members, meaning that each member
oversees two teams. The board members can thus give the teams their full attention and deliver
results together. In particular, the integration of the licensing and enforcement teams into the
supervision function should greatly improve the results of our work. We will modernise the

payment system as well. We have also rationalised every department at the bank. The number
of job positions at the CNB was reduced by 5.1% in 2023. This was the first time the central
bank's operations had been comprehensively streamlined in ten years. This allowed wages at
the bank to rise without dramatically increasing operating expenses. Wages at the CNB will
continue to go up, because we want to reward our people well and attract the best possible
employees, including some of you.

We managed to end 2023 with a profit of CZK 55.1 billion. We therefore erased part of our
accumulated loss of previous years in 2023. However, our asset and liability structure is not yet
such as to allow us generate a profit on a sustained basis, and we need to continue to make
changes.

CNB financial results

y, Profit/loss in current year Cumulative profit/loss at year-end
ear

(CZK billions) (CZK billions)
2022 -412 -487
2023 +55 -432
Source: CNB

In particular, we are going to increase the expected return on our assets and diversify them. This
process should be aided by the gradual purchase of gold up to a total of 100 tonnes, which
would be the largest amount in the CNB's history (for comparison: in 2019 we had 8 tonnes of
gold in our vaults, an all-time low). We are also going to gradually increase the share of equities
over the next few years. If you are interested in this issue, I recommend you read the findings of
the research we conducted with my colleagues Tomas Adam and Michal Skoda (Adam, Michl,
Skoda, 2023). I cannot guarantee that we will record a profit again this year. But I will do all I can
to leave the next governor a better balance sheet and profit and loss account than I inherited.

We are also changing the CNB's corporate culture. Professionalism, teamwork, hard work and
the drive to do new things - that's what we are trying to impress on our staff. We are also
supporting the rapid adoption of new technology, including artificial intelligence. I intend to
cultivate and promote morality, ethics and decency at the Bank. Each of us should be of upright
and exemplary character. People who are guided by universal values and have character tend
to achieve their goals, be happy at home and at work and have a higher purpose in life than
envy, defamation and malice.

So much for the example we at the CNB want to set in terms of the proper functioning of the
institution.

In our line of work, it will always be about getting the three-body problem right - how to reconcile
the markets, the central bank and the government.

An example: Paul Samuelson, the 1970 Nobel Prize winner, advocated big government with big
spending after World War Il. He drew heavily on the teachings of J. M. Keynes, hence
Keynesianism. Milton Friedman (Nobel Prize 1976) recommended small government. He drew
on the theories of Adam Smith and Friedrich Hayek. After World War II, Keynesianism was the
economic mainstream. Then came the era of monetarism. Contemporary economists and
politicians are again more Keynesian. It almost seems as if we are going round in circles in
economics as the currents of opinion shift.

But sometimes we criticise the invisible hand of the market of the father of modern economics,
Adam Smith, without also adopting his ethics and morals. And similarly, many politicians now
invoke Keynesian policies, pumping money into the economy and buying and supporting what
they can. But before that, they have abandoned his other argument about budget surpluses in
times of prosperity to save for bad times. For example, the Czech government talks about
reducing the government deficit. But the government deficit rose (external link) last year
according to Eurostat methodology. So the budget had an inflationary effect. I mention this
because defeating inflation in the long term is conditional on coordination between bodies -
between monetary and fiscal policy. If fiscal policy records increasing budget deficits even in
good times, 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.

You know, we keep trying to help the economy, but it would be better to start with properly
functioning institutions, led by the central bank and the government. They determine how the
free market will work, which is the subject of another branch of economics called institutional
economics. Then there's the importance of respect for the law, law enforcement and the judicial
system. For my part, I can say that the CNB will conduct monetary policy in such a way as to
maintain price stability. I expect rates to be higher than we were used to in the ten years before
Covid. I would like the government to achieve balanced public finances on average and to
reverse the thinking that the state will solve all the problems that may arise in the economy.
That's the only way to achieve low inflation in the long term. That's the only way to achieve a
balance between the three bodies in the economy.

References

Adam, T., Michl, A., Skoda, M. (2023). Balancing volatility and returns in the Czech National
Bank's foreign exchange portfolio. CNB, RPN No. 1/2023.


Michl, A. (2022a). Speech given by Ales Michl on his appointment as Governor. Appointment of
CNB Governor, Prague. 11 May 2022.

Michl, A. (2022b). Policy for a strong koruna. CNB Discussion Forum. Faculty of Economics and
Administration at Masaryk University, Brno. 23 November 2022.

Michl, A. (2023a). Inflation: The road to the target. University of Economics and Business,
Prague. 15 May 2023.

Michl, A. (2023b). The road to the target Il. CBAAssembly of Members Czech Banking
Association, Prague. 15 June 2023.

Michl, A. (2023c). The road to the target Ill. CNB Discussion Forum 2023. Tomas Bata
University, Zlin. 17 October 2023.