Dr Zdenek Drabek
Prague, 22 June 2022
When inflation in Turkey rose to 11% in early 2020, President Erdogan accused the central bank of professional incompetence. As the origin of inflation, the president evaluated factors that he characterized as “imported” and considered inflation as “costly”. He rejected the central bank’s proposal to tighten monetary policy with higher interest rates, which he saw as an obstacle to his visionary policy of promoting economic growth. His criticism resulted in the firing of the governor of the central bank, and when his successor saw no other possibility of leading against inflationary policy than by tightening monetary policy, he was also replaced. While the central bank has tried to tame inflation with higher interest rates, President Erdogan has prescribed it to support economic growth while pushing inflation to lower numbers without raising interest rates or even lower rates. The result was a dramatic acceleration of inflation to nearly 16% a year later and to 36% by December 2021. Since then, the monthly rate of inflation has continued to accelerate – rising to 56% in February and a terrifying 70% in April.
President Erdogan rejected expert suggestions for solving the central bank problem, ignored the recommendations of the IMF and a financial expert with experience associated with stabilization policy in other parts of the world, and pretended to be a financial and macroeconomic expert. His anti-inflation policy in Turkey has obviously failed and is currently leading the Turkish economy into a spiral of hyperinflation, which could lead to state and corporate bankruptcy and the complete destruction (devaluation) of people’s savings and deterioration of living standards, all leading to a very dangerous destabilization of society. His intervention essentially eliminated the central bank’s independence in its decision-making and in fulfilling its objective, which is primarily the maintenance of price stability.
Pressure on CNB
Fast forward to Central Europe – and the Turkish lesson seems to be a classically frightening example for the current Czech situation. We are all watching the development of inflation in the Czech Republic with great concern, and the inflation numbers are truly dramatic and are still growing. Inflation in CR is the second/third worst in the entire European Union and we are already consulting such pariahs as Argentina and Russia, not to mention Turkey. The CNB has been reacting for a long time with quite a few increases in interest rates, but these are obviously not popular and lead to sharp criticism of the CNB. Recently, President Zeman, trade unions and the Chamber of Commerce entered the debate, in addition to those from whom comments are expected, such as bank economists, financiers or entrepreneurs. This is quite natural – inflation is a problem not only economically but also socially, and due to the changing of the guard at the position of the CNB governor, which is happening right now, it is also a problem politically. (As a reminder, the CNB is formally an independent institution and the governor of the CNB is appointed by the president of the republic. Both functions are given by our constitution).
The main subject of the dispute are the recent interest rate increases by the CNB and the general tightening of monetary policy. Critics of the CNB see in higher rates primarily serious impacts on citizens with mortgages and fear of provoking economic recession/stagnation, just as President Erdogan sees it in Turkey. Two members of the bank board voted against raising rates, which they see as an obstacle to economic growth and the competitiveness of Czech companies. The SPD rejects raising interest rates and suggests that the CNB use other instruments. In addition to the absurd requirement of targeting hard – i.e. of the overvalued CZK exchange rate did not specify those instruments. Former finance minister and member of the Babis government, Schillerova, as is well known, called interest rate increases “a policy typical of developing countries”, a statement that does not exactly suit her as an expert in economic theory. However, no one gives specific proposals except for the already mentioned SPD proposal to reduce inflation, and critics of the CNB can only hope that inflation will end with economic growth or with some kind of magic wand.
The pressure on the CNB started long before the start of the current inflationary spiral. Interest rates were kept at a very low level for a long time in order to support economic growth, but even this policy was not satisfactory for the Babiš government at a time of increasing spending justified by Covid. The Babis government therefore decided to take a radical step and that was the enactment of new rules for the financing of public expenditures by the central bank with the aim of ensuring the government’s access to additional financing of expenditures and an effort to maintain low interest rates even in the long term. CNB’s reaction at the time was surprising. Even though it tried to present itself as a (“reluctant”) unwilling participant of this pressure, the CNB allowed itself to be maneuvered into a completely new system of its functioning. Given the size of the increase in the budget deficit, which was completely out of its control, the CNB must have been aware of the great risk of its policy. The nomination of A. Michl as the new governor is now putting new pressure on the CNB. Michl is the main representative of the part of the CNB that did not support interest rate increases and his personality and ideas correspond best to President Zeman’s ideas about the way the CNB’s monetary policy should be conducted.
Why did CNB have to react?
Did the CNB have to act by raising interest rates? The short answer to this question is yes. And for several reasons. As given by the mandate of the CNB, the main objective of the CNB is price stability. The majority of the bank board is and was evidently aware that price stability in the market was seriously disturbed, the low level of interest rates was unsustainable, and that action was needed. In addition, the CNB worked for a long time with a target inflation of 2%, and it is therefore evident that it did not meet its target and failed in terms of this goal. The CNB was and is aware (that is, at least some members of its bank board) that with its monetary policy it also greatly complicated the inflationary situation in the market and that inflationary pressures are not transitory, which is the reason why it is trying to push inflation down and started quickly raising interest rates.
CNB explains its policy by the need to influence the expectations of companies, families, and investors regarding future price developments. To this I also add the expectations of the state. Expectations of continued inflation can greatly influence the development of wages and prices of final products and services, and central banks are the only economic policy institution that can influence inflation expectations. A specifically Czech problem is that inflation is heavily fueled by budget policy. The balanced state budget policy from the pre-covid period shot the budget deficit to a historically high level of 6.5% of GDP in 2020, and the deficit continued to grow in 2021. What made the Czech inflation unusual is that the average EU inflation is roughly half the Czech one. Switzerland, which is also heavily dependent on the import of raw materials and energy and has its own currency and is not subject to ECB rules, has inflation of around 2%. For the EU, it is estimated that 2/3 of inflation originates from external factors. Given the twice higher rate of inflation in the Czech Republic than in the EU, it can be assumed that the majority of Czech inflation is driven by domestic factors. Inflation in the Czech Republic is, therefore, not only “cost-driven”, but strongly demand-driven and formed by macroeconomic policy (i.e. “policy-induced”) and various structural – purely specifically Czech factors. The CNB really had to give a signal that it will not tolerate price increases and will do everything to anchor the price development at a low level. Evidence provided in a recent IMF/MMF study shows and documents the importance of well-grounded inflation expectations and confirms that CNB acted correctly.
The CNB targeted inflationary pressures resulting from specific institutional and market conditions. An increase in the budget deficit does not automatically translate into purchasing power in the market, if the deficit is not channelled into financing higher consumption. Japan, with its deficit as high as CR, has an estimated inflation of below 2% in 2022. The key explanation for the Japanese “miracle” is the large share of financing the deficit by bond sales to households. These transform higher household incomes into savings and investments, and not into consumption. Another Czech specificity is the inflationary growth of wages. The CNB estimates that nominal income growth is much faster than productivity growth. In the market environment, this automatically means pressure to increase the prices of final products.
In addition to the loss of the purchasing power of money, inflation has other undesirable effects that the CNB had to respond to. Inflation threatens the competitiveness of Czech companies, reduces the motivation to save and thereby increases the support for consumption, which in an inflationary and overheated market is the exact opposite of the optimal policy of financial stabilization. The rapidly growing monetary demand began to spill over into the balance of payments, which has seen the greatest deterioration in recent years (along with Greece, CR today has the worst current account balance of payments, and this represents another destabilizing factor). In addition, low interest rates significantly increased the risk of outflow of domestic and foreign capital abroad, which actually occurred and strongly weakened the exchange rate of the koruna and forced the CNB to intervene in the foreign exchange market in an effort to maintain exchange rate stability. Foreign exchange interventions mean the loss of foreign exchange reserves. The financial needs of the state have grown so much that they have led to various adjustments to the functioning of the central bank and calls for unconventional interventions by the CNB.
Critics of the Euro zone must be reminded that that CNB is not and cannot entirely independent as the cricis argue and wish. CNB is “forced“ to “shadow” expected interventions of the ECB. If the ECB raises interest rates, it is unthinkable these days that the CNB will not do the same, sooner or later. The fact that the CNB was the first to raise interest rates only documents its expected rate hikes by the ECB, which are now taking place. Differences are always just a matter of time. The CNB acted quite correctly with its increases in interest rates. It had to (1) dampen excessive demand, (2) demonstrate its determination to reduce inflation to reasonable numbers, and (3) protect the Czech economy from destabilizing capital flight.
How to protect economic growth? – “Hard or soft landing?”
Criticism of CNB (including criticism of of higher interest rates in the Monetary Board) is focused on the argument that a restrictive policy will cause an economic recession. This criticism ignores the fact that higher interest rates do not necessarily mean, ceteris paribus, lower economic performance. First, higher debt service caused by higher interest rates will typically affect large enterprises less than small and medium-sized enterprises, since they are much less dependent on credit, and it is large enterprises that drive economic growth in the CR. Secondly, higher interest rates also do not mean a critical environment for small and medium-sized enterprises as long as they face a reviving demand for their services, as it happening today in the tourism scetor. Third, higher interest costs often lead to a search for internal corporate savings and thus can support productivity growth. Fourth, higher interest rates push investors into more profitable projects and more efficient use of capital. Evidence from the Czech economy suggests to some extent that these processes are indeed taking place at this moment, as evidenced by the growth figures from the first quarter of this year.
It goes without saying that the higher interest rate has a restrictive effect, and the question is whether and to what extent it will negatively affect economic growth. The impact will depend not only on the development of foreign markets but also on the government’s fiscal and structural policy. It is necessary to emphasize that the Czech government could have done much more to support domestic companies and thus economic growth and to suppress an overheated labor market. From this point of view, the problems of our macroeconomic policy are twofold. First, there is no coordination of monetary and fiscal policies with the aim of a unified anti-inflation and growth strategy. Secondly, the Babis’s government also did not use structural policy tools that would have allowed to eliminate or at least mitigate the impact of Covid, Ukraine and world market problems.
The problems of monetary and fiscal policy coordination manifested themselves in the first phase of the covid crisis, when the Babis government had to increase support for households. Aggregate demand was boosted by nominal income growth in both the private and public sectors in the form of various supports for families, single mothers, small and medium-sized enterprises, and even large multinational corporations during the covid recession. This growth in aggregate demand occurred at a time of collapsing manufacturing and services and led to increased liquidity and a monetary surplus. Fiscal expansion was inflationary. In this situation, the Babis government was desperate for access to cheap financing of public spending, and to do so, it used pressure on the CNB to keep interest rates low and legally adjusted higher limits on government bond financing by the central bank.
Nowhere is it given that fiscal and monetary policy must always point in the same direction. There are situations where fiscal measures are desirable and unavoidable, such as measures to support the household were mostly affected by the covid and Ukrainian crisis. In a situation where the government was rapidly increasing its current expenditure on household support, the CNB should have responded by raising interest rates at the same time – it would have enabled the financing of family support, but at a higher cost to the budget.
The CNB reacted to the risks of inflation much faster than the Ministry of Finance. This is understandable, as monetary policy is the only effective tool for combating inflation if it is necessary to influence the expected development of future prices. The effect of monetary policy is also typically faster than the effects of fiscal policy. Fiscal policy, however, underwent a change and with the advent of the new government coalition, greater control over the development of the fiscal deficit and a more reasonable evaluation of social and consumer supports.
However, the biggest problem of economic policy is the total disagreement about the origin of inflation. This also causes disagreement in the importance of economic policy priorities – the role of growth, inflation and social support. Critics of the CNB assume that we cannot control inflation and claim that the only solution is to support economic growth. The CNB rightly points to the domestic factors of inflation – budgetary policy and inflation expectations, and the result is that the priorities are created by the policy of one institution somewhat at the expense of the priorities of the other institution. And there is no agreement at all about which policy or its mix is optimal and most effective.
The optimal policy of the government at this time should be anti-inflationary in the case of the CNB and, if possible, pro-growth as much as possible in the case of the budget. Fiscal policy must play a greater role in supporting growth. However, this does not happen; fiscal policy is greatly influenced by ongoing pressures to adopt various social programs in connection with the upcoming presidential election, which continues to focus the government’s attention on social programs, military spending, energy strategy, and thus also on tax and spending budget adjustments. All the energy of the coalition government is focused on articulating the needs of families to support the growth of food, housing and energy. Anti-inflationary and pro-growth measures of fiscal policy are falling by the wayside.
A return to economic growth?
In addition to fiscal policy, the pro-growth trajectory of government policy should be strengthened by structuralal policy that would lead to a better functioning of the market. These are problems associated with market limits or imperfections that limit the performance of the Czech economy and which should be the focus of government policy. For example, low interest rates are useless if firms are unable to find new workers. Labor shortages and low unemployment are currently major obstacles for companies looking for new employees and are barriers to growth. Low interest rates had no effect on the performance of the public investment sector. It is regrettable that the National Reconstruction Fund, which was so much celebrated in public, basically did not start at all due to the inability to produce meaningful and economically and financially defensible projects. The growth of investments financed from national (not foreign) sources could have been a source of growth in a situation where the export sector was troubled by problems in the European market. Domestic financing of these investments would also serve as an anti-inflation policy.
Another example concerns the position of small and medium-sized enterprises in the market. Support for these companies threatened by higher interest rates could be not only a tool to prevent bankruptcies but also another strong anti-inflationary measure. The condition, however, is that these supports are tied to improving competitiveness and not just income support, which obviously did not happen or happened slowly in the case of support for 700,000 small entrepreneurs – despite the promises of the former of Minister Havlíček (Law 18.5.2022). Not much attention was paid to the effectiveness of different social supports either. It is self-evident that in certain situations the government must react quickly and unbureaucratically, but it is surprising that when adopting individual social programs so little attention was paid to explaining to the public the advantages and disadvantages of specific measures. The state of support for single mothers escapes understanding even the author of that comment. State subsidies aimed at protecting the income of workers have indeed supported their employment, but at the same time create additional tension in the labor market. On the other hand, in a situation where large companies accumulated historically highest profits in the pre-covid period, support for these companies is difficult to understand.
My other example from the labor market concerns the public sector wage system. Government policy is becoming a major player in the labor market these days. By increasing the salary of civil servants, the state even became, to a certain extent, an agent that labor market economists call a “wage setter”, an agent influencing the growth of wages and salaries in the private sector as well. Rising salaries led not only to a monetary surplus, but also to pressure on companies to increase their workload. I would venture to say that these expenses were pro-inflationary, and due to the tight labor market, the wage policy of civil servants leads to pressures to increase wages and labor costs and to seek a solution in the form of higher prices of final products and services in the private sector as well.
These problems are the responsibility of line ministries in cooperation with the Ministry of Finance. However, the CNB is also responsible for one important area of structural policy, and that is exchange rate policy. The koruna exchange rate critically affects the role and share of tradable and non-tradable products and services, which is another key priority of the Czech economy. A strong exchange rate increases the price of tradable goods relative to non-tradable goods and thus complicates the performance of this sector compared to a sector that is not exposed to foreign competition. In today’s situation, there is a big disadvantage of own monetary policy and non-membership in the Euro-system, because the CNB is thus unable to maintain price stability, free movement of capital and a stable exchange rate – all three at the same time (which is well known to economists as the “impossible trinity”). Supporting economic growth requires an exchange rate that supports the tradable goods sector, which can lead to pressures to soften the exchange rate. However, the CNB needs a stable exchange rate to control inflation and inflationary pressures, and this was the reason for its interventions in the foreign exchange market. Today’s “stable” exchange rate against the Euro can be helpful in the inflation control policy, but in a situation where inflation in the Czech Republic is around 16% and inflation in the EU is around 8%, the CNB will soon have to ask whether the exchange rate it stabilized is not overvalued.
Higher CNB interest rates are likely to slow economic growth. The question is whether the anti-inflation policy will end in a painful fall into a deep recession (“hard landing”) or only a relatively favorable slowdown in growth (“soft landing”). Anti-inflationary policy may not lead to a fall if the CNB succeeds in breaking inflationary expectations without leading to higher unemployment and if it is better coordinated with fiscal policy and if it is not linked to catastrophic conditions in foreign markets. Fiscal policy must not overheat the market, but should support economic growth. Macroeconomic policy with the goal of economic growth and prosperity linked to price and financial stability will only be successful if the CNB and government institutions work together. “Soft landing” and the return to growth will depend on the identification and solution to the market distortions that slow down growth and its proper functioning, and thus on the implementation of structural policy. Today’s bank board has sufficient expertise in this area as well (NERV and MF), which should simplify the CNB’s communication with the government.
Dr. Zdenek Drabek is an expert in trade policy and foreign investment. His primary professional aim is to help governments, private sector companies, consumers and civic society at large to understand appraise and decide about the value of trade and investment rules and trade and investment governance. His expertise is driven by his unique background skills, and experience which combine practical experience in top policy advice with deep economic analysis and strong academic origin.