## _wp1574

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---

### I. Introduction and main policy shift
- Documents how the Czech National Bank (CNB) moved from a fixed exchange rate regime toward Inflation-Forecast Targeting (IFT) and added the exchange rate as a tool to combat deflationary risks.
- Key facts:
  - Initial post-1998 regime described as "IT Lite" before adopting a forward-looking FPAS in 2002.
  - FPAS supported an explicit IFT framework with endogenous interest rates.
  - The CNB began publishing the projected interest rate path in 2008Q1.
  - Policy interest rate reached the zero lower bound (ZLB) by November 2012; the policy rate was technically 0.05 percent.
  - In November 2013 the CNB decided to use the exchange rate as a complementary monetary policy tool.

### II. Historical context and motivations
- Pre-2002 developments:
  - 1991–97: fixed exchange rate regime; band widened to +/- 7.5 percent in 1996.
  - Early 1997 crisis: about 20 percent of reserves used to defend the peg; interest rates rose from 12 percent to 26 percent; peg abandoned and exchange rate depreciated by 13 percent.
  - Interbank one-week PRIBOR rate peaked at 75 percent in the crisis.
- 1998–2001/2: "IT Lite"
  - Managed float with continued interventions through 2002.
  - Lack of forward-looking framework led to excessively cautious policy, interest rates kept too high for too long, undershooting of inflation, protracted recession and high unemployment.
  - Unemployment peaked at 9.3 percent in 2000.
- 2001/2–2007/8: move to full-fledged IFT supported by FPAS
  - FPAS elements: organizing staff resources, constructing a quarterly projection model (QPM), multivariate filter for potential output/NAIRU, risk analysis and confidence bands, integrating near-term expert forecasts with medium-term QPM-based forecasts.
  - QPM permitted publishing a forecast-consistent policy rate path with endogenous interest rates.

### III. FPAS, IFT, and forward guidance practices
- Rationale for model-based, forward-looking framework:
  - Handles lags, expectations, nonlinearities (e.g., ZLB) and enables clearer communication of policy trade-offs compared with Taylor-rule–type approaches.
- Endogenous interest rate forecasting:
  - Forecasts use completely endogenous policy rates—rates that ensure projected inflation returns to target over the policy horizon.
  - Publishing the projected policy rate path clarifies the conditional nature of the forecast; confidence intervals are published to stress non-commitment.
  - The CNB started publishing the projected interest rate path (with confidence intervals) in 2008Q1.
  - Five IFT central banks published explicit projected paths at that time.

### IV. November 2013 decision to use the exchange rate as a complementary tool
- Background drivers:
  - Post-euro-crisis weakness: six consecutive quarters of negative GDP growth in 2011Q4-2013Q1 (based on data available when drafted).
  - Policy rate at ZLB by November 2012 (0.05 percent) and expected to remain at the ZLB until at least the end of 2015 (at time of drafting).
  - Limited scope for quantitative easing due to long-term liquidity surplus in Czech banking system and relatively shallow private debt markets.
  - Core inflation remained negative even though headline inflation temporarily rose above the new 2 percent target due to indirect tax increases and some cost-push shocks.
- Announcement and operational detail:
  - On November 7, 2013 the CNB announced it would intervene to weaken the koruna so that the exchange rate of the koruna against the euro is close to CZK 27.
  - The CNB emphasized the exchange rate was an additional tool to ease monetary conditions to achieve existing inflation and output objectives—not a new nominal target.
  - The announced exchange rate floor could be changed as economic circumstances required; communicated as analogous to changing the policy interest rate in normal times.
  - Exit strategy: stop using the exchange rate tool when necessary to tighten monetary conditions to ward off inflation pressures.
  - Intervention commitment was one-sided: CNB would prevent excessive appreciation below CZK 27/EUR by selling koruna and buying euro; on the weaker side it would allow the koruna to float.

### V. Theoretical motivation (illustrative)
- Svensson (2001) framework summarized:
  - Temporarily pegging at a depreciated exchange rate can increase aggregate demand, inflation, and expected inflation.
  - Higher expected inflation reduces real interest rates, supporting the economy when nominal policy rates are at the ZLB.
  - Abandoning the peg later and returning to price-level or inflation targeting preserves long-run inflation anchoring.
- Concerns:
  - Whether expectations will behave as hypothesized.
  - Potential international spillovers, especially if used by larger countries; smaller economies may have relatively smaller short-run spillovers.

### VI. Communications and managing expectations
- Communications central to success:
  - Clear statements and detailed Q&A on the CNB web site accompanied the November 7, 2013 decision.
  - 2013 IV Inflation Report contained a box “Using the Exchange Rate as an Instrument to Ease the Monetary Conditions” and presented an alternative “exchange rate tool scenario” showing objectives could be achieved with a policy rate just above the ZLB if the koruna shifted close to CZK 27/EUR.
  - 2014 Q1 Inflation Report box provided illustrative pass-through: approximately 24 percent of the CPI is imported and consumed directly, plus an additional 9 percentage points imported as intermediate inputs that reach the final consumer basket.
  - CNB communicated the exchange rate tool was temporary and conditional, aiming to raise short-term inflation expectations without de-anchoring long-term expectations.

### VII. Implementation: the FX floor and interventions
- Market reaction and intervention facts:
  - On November 7, 2013 the koruna moved from 25.8 to the euro just before the announcement (1 pm) to almost 27 immediately afterwards, ending the day at almost exactly 27.
  - The CNB intervened for just a few hours over two days, buying foreign exchange for a total of about 8 billion euros (about 5 percent of GDP).
  - Since November 2013 the koruna traded higher than 27 without further CNB intervention.
- Reasons limited intervention sufficed:
  - Communications convinced market participants the CNB was using the exchange rate as an instrument rather than adopting a new target.
  - Markets understood the CNB had effectively unlimited intervention power on the buy side (preventing appreciation below CZK 27/EUR).

### VIII. Preliminary assessment (after one year)
- Two key evaluation questions:
  - How have the CNB and markets adjusted to the new framework and their understanding of how it operates?
  - What are the effects of the policy announcements and actions on the exchange rate and consequently on inflation and output developments?
- Early observations:
  - Exchange rate framework was new; a preliminary evaluation is warranted after more than a year since November 2013.
  - Longer-term inflation expectations have remained well anchored at 2 percent.
  - Headline and short-term inflation proved weaker than expected due to factors including subdued euro-area inflation, weak wage growth, administered prices not moving as projected (some declined), and sharp falls in international petroleum prices starting in the second half of 2014.
  - The depreciation lifted prices of imported goods and the volume of exports, helping to avert deflationary tendencies.
  - Economic growth picked up in line with the CNB forecast made in late 2013.
  - Consensus Forecasts:
    - Projected GDP growth for 2014 increased from under 2 percent in late 2013 to around 2½ percent by August 2014.
    - Consensus Forecasts for 2015 show GDP expected to increase by around 2½ percent.
    - Wages expected to pick up to more than 3 percent in 2015.
    - CPI inflation projected to slide to ½ percent in 2015.

### IX. Adjustment to the new framework (IIIf.1)
- Framework design and flexibility:
  - Exchange rate became an additional instrument for achieving monetary policy goals; explicitly not a fixed exchange rate framework.
  - Announced exchange rate level could be changed over time in response to new information about inflation and output.
  - CNB minutes (November 7, 2013) noted “[the short-term] target level for the exchange rate could not be subject to frequent modifications.”
  - By mid-2014 minutes noted it was “not possible to rule out a future need to change the intervention level of the exchange rate in the weaker direction.”
  - CNB described the arrangement as asymmetrical: prevent appreciation below CZK 27/EUR by using FX interventions; on the weaker side allow market-determined movements.
  - CNB Board on July 31, 2014 stated it “would have to find a further noticeable increase in anti-inflationary factors before moving the exchange rate commitment to a weaker level.”
- Exchange rate behavior and communication outcomes:
  - Since November 7, 2013, koruna generally traded in a range near 27.5 to the euro.
  - 2014 Q2 CNB Inflation Report: average exchange rate CZK 27.4 in 2014 Q2, year-on-year depreciation of 6.3 percent, quarter-on-quarter stability; koruna fluctuated between CZK 27.3 and CZK 27.5 and spent most of the period just above CZK 27.4.
  - Koruna was 0.3 percent weaker than the forecast for 2014 Q2 (CZK 27.3).
  - Footnote: “Since November 2013, there has been no further CNB intervention.”

### X. Effects on inflation and output (IIIf.2)
- Communication credibility and outcomes:
  - Communications worked; market participants understood the strategy and believed it credible.
  - Longer-term inflation expectations remained anchored at 2 percent.
- Macroeconomic effects:
  - Depreciation raised import prices and export volumes, helping avert deflationary tendencies.
  - Economic growth recovered in line with CNB forecasts.
  - Major exception: CPI inflation was weaker than expected due to external and domestic factors noted above.
- Forecast alignment:
  - Forecasts and consensus views suggested that future strength of the economy and inflation removed the need for further depreciation at that time.

### XI. Tentative conclusions
- The CNB added exchange rate policy as an additional tool rather than pursuing quantitative/qualitative easing; this approach has clearer linkages to aggregate demand and inflation than some unconventional policies.
- Early evidence indicates economic and inflation developments moved largely as expected.
- Exiting the exchange rate floor framework presents challenges:
  - An early exit might surprise markets.
  - A delayed exit might raise questions whether the floor has become a new objective rather than a temporary tool.
  - The CNB attempted to address this by specifying the earliest date for exit from the framework.
- Lessons and caveats:
  - The strategy can work only if the central bank has considerable credibility; CNB’s IFT framework noted as one of the most advanced with excellent forecasting/nowcasting capacity and strong communication.
  - Economic structure matters: as a very open economy, effects of depreciation on demand and inflation are larger than in more closed economies; as a small economy, approach raises fewer beggar-thy-neighbor concerns.
- Overall assessment: CNB’s use of the exchange rate as a tool for easing monetary conditions is path-breaking; only time will tell whether it will provide a model for other countries.

### XII. Appendix I — Selected Q&As (key operational and policy points)
- Aim: maintain price stability in line with the CNB’s inflation target of 2 percent (since 2010); limit deflation risk and accelerate return to conditions where interest rates can be used again.
- Timing: Bank Board decided to use the exchange rate as a tool and to commence interventions on 7 November 2013.
- Rationale for FX interventions:
  - For a small open economy with long-term excess liquidity in its banking sector, FX interventions are more effective than other options.
  - Use of FX interventions to counter deflation risks was recommended by an IMF mission.
  - Bank Board decided in autumn 2012 that the koruna could serve as an additional tool once the lower bound on interest rates was reached.
- Operational design:
  - Financial Markets Department will purchase foreign currency as needed to achieve desired easing.
  - CNB will intervene to weaken the koruna to maintain the exchange rate close to CZK 27/EUR.
  - Commitment is asymmetric (one-sided). There is no limit on the amount of purchases; the CNB can purchase any amount of foreign currency.
  - Bank Board meets eight times a year and may hold extraordinary meetings.
- Implications for future exchange-rate evolution:
  - CNB prevents appreciation below CZK 27/EUR by selling koruna and buying euro; on the weaker side allows market-determined movement.
  - Bank Board may change the maintained level at subsequent meetings based on macro forecasts or risk assessment; changes would likely require a much stronger impulse than interest-rate changes.
  - Bank Board foresees the present exchange rate commitment being maintained at least until the start of 2015.
- Expected economic effects:
  - Weaker koruna increases import prices and domestic price level; to a lesser extent boosts domestic activity.
  - Support for exports, corporate profitability, investment, and recovery in production is expected to contribute to higher employment and wages.
- Comparison with past interventions:
  - Last intervened in 2002. 2002 interventions aimed to prevent tightening of monetary conditions and reduce volatility at non-zero interest rates; current interventions solely to ease monetary conditions through the exchange rate at the technical zero lower bound (0.05 percent).
- Conditions for discontinuation:
  - Use of the exchange rate tool will be discontinued when it becomes necessary to tighten monetary policy significantly because of very substantial inflation pressures.
  - Discontinuation achieved by stopping interventions and then raising interest rates above technical zero; the decision will be announced after the Bank Board decision.
- Further clarification from the November 2013 Inflation Report:
  - Recognizes scope for lowering policy rates was exhausted on reaching technical zero (0.05 percent).
  - States it is impossible to lower 3M PRIBOR market interest rates below technical zero plus the risk premium between PRIBOR rates and the 2W repo rate.
  - Alternative scenario: exchange rate takes over the stabilizing role of monetary policy; weakening to CZK 27/EUR accelerates return of inflation toward 2 percent and allows earlier exit from the ZLB.
  - “The level close to which the CNB will maintain the exchange rate will be publicly announced on the day the decision is made.”

*Source: Appendix II and related sections of the IMF working paper chapter titled "Further Clarification by the CNB Regarding its November 2013 Policy Decision to Use the Exchange Rate Tool."*

### References.................................................................................................23

### _wp1574 - References.................................................................................................23

### Figures
- Figure 1: Czech Koruna and the History of Monetary Policy Regim
es ..................................26
- Figure 2: Unemployment Rate and Real GDP .........................................................................26
- Figure 3: Nominal & Real Interest Rates .................................................................................27
- Figure 3: Nominal & Real Interest Rates .................................................................................27
- Figure 4: Inflation and Inflation Expectations .........................................................................28
- Figure 5: Central Bank View of the Transmission Mechanism ...............................................29
- Figure 6: February 7, 2008 Inflation Report (continued) ........................................................30
- Figure 7: November 6, 2008 Inflation Report .........................................................................31
- Figure 8: Interest Rate Projections around November 6, 2008 ................................................32
- Figure 9: November 7, 2013 Inflation Reports ........................................................................33
- Figure 10: Interventions and Koruna/Euro Exchange Rate(Jan 2013 - Aug ...........................34
- Figure 11: Hourly Koruna/Euro Exchange rate (Nov 7, 2013, 8:00-17:00) ............................34
- Figure 12: Daily Koruna/Euro Exchange Rate (Jan 2013 - Sep 2014) ....................................35
- Figure 13: Evolution of Consensus Forecasts for 2014 and 2015 for Major ...........................36

### Appendices
- Appendix I. Selected Q&As from CNB in November 2013 ...................................................39

*Source: _wp1574 - References.................................................................................................23*

### Appendix II. Further Clarification by the CNB Regarding its November 2013 Policy Decision to

### Appendix II. Further Clarification by the CNB Regarding its November 2013 Policy Decision to Use the Exchange Rate Tool

### I. Introduction and main policy shift
- The paper documents how the Czech National Bank (CNB) moved from a fixed exchange rate regime toward Inflation-Forecast Targeting (IFT) and how it added the exchange rate as a tool to combat deflationary risks.
- Key contextual facts and markers:
  - The CNB’s initial post-1998 regime was described as "IT Lite" before adopting a forward-looking FPAS in 2002.
  - The FPAS supported an explicit IFT framework with endogenous interest rates.
  - The CNB began publishing the projected interest rate path in 2008Q1 (one of five IFT central banks to do so at the time).
  - The CNB brought its policy interest rate to the zero lower bound (ZLB) by November 2012; the policy rate was technically 0.05 percent.
  - In November 2013 the CNB decided to use the exchange rate as a complementary monetary policy tool to stimulate the economy and reduce deflation risks.

### II. Historical context and motivations
- Pre-2002 developments:
  - 1991–97: fixed exchange rate regime; band widened to +/- 7.5 percent in 1996.
  - Early 1997 crisis: about 20 percent of reserves used to defend the peg; interest rates rose from 12 percent to 26 percent; peg subsequently abandoned and exchange rate depreciated by 13 percent.
  - Interbank one-week PRIBOR rate peaked at 75 percent in the crisis.
- 1998–2001/2: "IT Lite"
  - Managed float with continued interventions through 2002.
  - Lack of forward-looking framework led to excessively cautious policy, interest rates being kept too high for too long, undershooting of inflation, protracted recession and high unemployment.
  - Unemployment peaked at 9.3 percent in 2000.
- 2001/2–2007/8: move to full-fledged IFT supported by FPAS
  - FPAS major elements included organizing staff resources, constructing a quarterly projection model (QPM), multivariate filter for potential output/NAIRU, risk analysis and confidence bands, and integrating near-term expert forecasts with medium-term QPM-based forecasts.
  - The QPM made policy forecasts internally consistent with endogenous interest rates and permitted publishing a forecast-consistent policy rate path.

### III. FPAS, IFT, and forward guidance practices
- Rationale for model-based, forward-looking framework:
  - Taylor-rule–type approaches are overly simplistic; a model-based IFT handles lags, expectations, nonlinearities (e.g., ZLB) and enables clearer communication of policy trade-offs.
- Endogenous interest rate forecasting:
  - The CNB prepares forecasts with completely endogenous policy rates—rates that ensure projected inflation returns to target over the policy horizon.
  - Publishing the projected policy rate path enhances transparency and clarifies the conditional nature of the forecast; confidence intervals are published to stress non-commitment.
- Publication practice:
  - The CNB started publishing the projected interest rate path (with confidence intervals) in 2008Q1.
  - Five IFT central banks (including the Czech Republic) published explicit projected paths at that time.

### IV. November 2013 decision to use the exchange rate as a complementary tool
- Background drivers:
  - Post-euro-crisis weakness: six consecutive quarters of negative GDP growth in 2011Q4-2013Q1 (based on data available when drafted).
  - Policy rate at ZLB by November 2012 (0.05 percent) and expected to remain at the ZLB until at least the end of 2015 (at time of drafting).
  - Limited scope for quantitative easing due to long-term liquidity surplus in Czech banking system and relatively shallow private debt markets.
  - Core inflation remained negative even though headline inflation temporarily rose above the new 2 percent target due to indirect tax increases and some cost-push shocks.
- Announcement and operational detail:
  - On November 7, 2013 the CNB announced it would intervene to weaken the koruna so that the exchange rate of the koruna against the euro is close to CZK 27.
  - The CNB emphasized the exchange rate was an additional tool to ease monetary conditions to achieve existing inflation and output objectives—not a new nominal target.
  - The announced exchange rate floor could be changed as economic circumstances required; this was communicated as analogous to changing the policy interest rate in normal times.
  - The CNB clarified exit strategy: it would stop using the exchange rate tool when necessary to tighten monetary conditions to ward off inflation pressures.
  - The intervention commitment was one-sided: the CNB would prevent excessive appreciation below CZK 27/EUR by selling koruna and buying euro; on the weaker side it would allow the koruna to float.

### V. Theoretical motivation (illustrative)
- Svensson (2001) framework summarized:
  - Temporarily pegging at a depreciated exchange rate can increase aggregate demand, inflation, and expected inflation.
  - Higher expected inflation reduces real interest rates, supporting the economy when nominal policy rates are at the ZLB.
  - Abandoning the peg later and returning to price-level or inflation targeting preserves long-run inflation anchoring.
- Concerns noted:
  - Whether expectations will behave as hypothesized.
  - Potential international spillovers, especially if used by larger countries; smaller economies may have relatively smaller short-run spillovers.

### VI. Communications and managing expectations
- Communications were central to success:
  - Clear statements and detailed Q&A on the CNB web site accompanied the November 7, 2013 decision.
  - The 2013 IV Inflation Report contained a box “Using the Exchange Rate as an Instrument to Ease the Monetary Conditions” and presented an alternative “exchange rate tool scenario” showing that objectives could be achieved with a policy rate just above the ZLB if the koruna shifted close to CZK 27/EUR.
  - A 2014 Q1 Inflation Report box provided illustrative calculations of pass-through: approximately 24 percent of the CPI is imported and consumed directly, plus an additional 9 percentage points imported as intermediate inputs that reach the final consumer basket.
  - The CNB communicated that the exchange rate tool was temporary and conditional, aiming to raise short-term inflation expectations without de-anchoring long-term expectations.

### VII. Implementation: the FX floor and interventions
- Market reaction and intervention facts:
  - On November 7, 2013 the koruna moved from 25.8 to the euro just before the announcement (1 pm) to almost 27 immediately afterwards, ending the day at almost exactly 27.
  - The CNB intervened for just a few hours over two days, buying foreign exchange for a total of about 8 billion euros (about 5 percent of GDP).
  - Since November 2013 the koruna traded higher than 27 without further CNB intervention.
- Why limited intervention sufficed:
  - Communications convinced market participants the CNB was using the exchange rate as an instrument rather than adopting a new target.
  - Markets understood the CNB had effectively unlimited intervention power on the buy side (preventing appreciation below CZK 27/EUR).

### VIII. Preliminary assessment (after one year)
- Two key evaluation questions posed:
  - How have the CNB and markets adjusted to the new framework and their understanding of how it operates?
  - What are the effects of the policy announcements and actions on the exchange rate and consequently on inflation and output developments?
- The paper notes it is still early to draw definitive conclusions; a preliminary evaluation is warranted after more than a year since November 2013.

*Source: Appendix II of the IMF working paper chapter titled "Further Clarification by the CNB Regarding its November 2013 Policy Decision to Use the Exchange Rate Tool."*

### conclusions, given the lags in the effect of monetary policy, it is nonetheless useful to determine

### _wp1574 - conclusions, given the lags in the effect of monetary policy, it is nonetheless useful to determine

### IIIf.1 Adjustment to the new Framework
- The CNB introduced a framework in November 2013 in which the exchange rate became an additional instrument for achieving the goals of monetary policy; this was explicitly not a fixed exchange rate framework.
- The announced exchange rate level could be changed over time in response to new information about inflation and output, particularly given significant downside risks to the Czech economy.
- The CNB emphasized maintaining a weak exchange rate for a sufficiently long period to provide stimulus; initial communications stressed reasons for the approach and implications of the initial depreciation rather than the possibility of subsequent changes.
- Minutes for November 7, 2013 noted that “the [short-term] target level for the exchange rate could not be subject to frequent modifications.”
- By mid-2014 the minutes noted “that it was also not possible to rule out a future need to change the intervention level of the exchange rate in the weaker direction, although the currently observed slight anti-inflationary risks did not warrant such a monetary policy response at present.”
  - This language alerted market participants that there was some probability of a future change in the announced exchange rate floor; lower than forecast inflation or a weaker outlook could raise the probability of future depreciation and cause the market rate to weaken below the announced rate.
- The CNB described the arrangement as asymmetrical: “The Board repeated that it regards the commitment as one-sided. This means that the CNB will prevent excessive appreciation of the koruna exchange rate below CZK 27/EUR by using FX interventions, i.e. by selling koruna and buying foreign currency. On the weaker side of the CZK 27/EUR level, the CNB is allowing the exchange rate to move according to supply and demand on the FX market.”
- The CNB Board on July 31, 2014 stated it “would have to find a further noticeable increase in anti-inflationary factors before moving the exchange rate commitment to a weaker level.”
- Exchange rate behavior and communication outcomes:
  - Since the November 7, 2013 announcement, the koruna generally traded in a range near 27.5 to the euro.
  - The 2014 Q2 CNB Inflation Report: “The average exchange rate of the koruna against the euro was CZK 27.4 in 2014 Q2. This represents a year-on-year depreciation of 6.3 percent and quarter-on-quarter stability. The koruna fluctuated in a very narrow band between CZK 27.3 and CZK 27.5 to the euro and spent most of the period in an even narrower range just above CZK 27.4 to the euro. The koruna was 0.3 percent weaker than the forecast for 2014 Q2 (CZK 27.3). In the first half of July, the koruna remained flat at around CZK 27.4 to the euro.”
  - “The exchange rate commitment of the CNB to maintain the exchange rate at CZK 27 to the euro remained the key factor affecting the exchange rate in the period under review (and so far this year). The exchange rate movements were in line with the asymmetric nature of the exchange rate commitment and still required no actual foreign exchange market interventions by the CNB.”
  - Footnote: “Since November 2013, there has been no further CNB intervention.”

### IIIf.2 Effects on Inflation and Output
- Communication credibility:
  - The policy was easy to implement because communications worked; market participants understood the strategy and believed it credible.
  - Longer-term inflation expectations have remained well anchored at 2 percent, as desired by the CNB, even as actual short-term inflation eased.
- Factors affecting inflation:
  - Administered prices did not move as projected; some declined.
  - Very subdued inflation in the euro area and weakness in wage growth earlier in the period negatively impacted Czech inflation.
  - International petroleum prices fell very sharply starting in the second half of 2014, pushing down headline inflation globally.
- Macroeconomic effects of the November 2013 decision:
  - The depreciation lifted prices of imported goods and the volume of exports, helping to avert deflationary tendencies.
  - Economic growth picked up in line with the CNB forecast made in late 2013.
  - Macroeconomic expectations broadly consistent with CNB communications and predictions, with the major exception of CPI inflation being weaker than expected.
- Consensus Forecast evolution:
  - Projected GDP growth for 2014 increased from under 2 percent in late 2013 to around 2½ percent by August 2014.
  - Consensus Forecasts for 2015 show continued strength: GDP expected to increase by around 2½ percent, with solid domestic consumption and investment growth and continued high growth in industrial production.
  - Wages are expected to pick up to more than 3 percent in 2015.
  - CPI inflation is projected to slide to ½ percent in 2015.
- These forecasts align with the CNB’s view that the future strength of the economy and inflation removes the need for a further depreciation at that time.

### IV. Tentative Conclusions
- The CNB added exchange rate policy as an additional tool rather than pursuing quantitative/qualitative easing; this approach has clearer linkages from central bank actions to aggregate demand and inflation than other unconventional policies.
- Early evidence indicates economic and inflation developments are moving in much the expected way.
- Exiting the exchange rate floor framework presents challenges:
  - An early exit might surprise markets.
  - A delayed exit might raise questions whether the floor has become a new objective rather than a temporary tool.
  - The CNB attempted to address this by specifying the earliest date for exit from the framework.
- Lessons for other countries must be drawn carefully:
  - The strategy can work only if the central bank has considerable credibility; the CNB’s Inflation-Forecast Targeting framework is noted as one of the most advanced in the world with excellent forecasting/nowcasting capacity, policymaker reliance on staff analysis, and strong communication.
  - Economic structure matters: as a very open economy, the effects of depreciation on demand and inflation are larger than in more closed economies; as a small economy, the approach raises fewer beggar-thy-neighbor concerns.
- Overall assessment: The CNB’s use of the exchange rate as a tool for easing monetary conditions is path-breaking, but only time will tell whether it will provide a model for other countries to follow.

*Based on: _wp1574 - conclusions, given the lags in the effect of monetary policy, it is nonetheless useful to determine*

### Appendix I. Selected Q&As from CNB web site in November 2013

### Appendix I. Selected Q&As from CNB web site in November 2013

### Aim of using the exchange rate as a monetary policy tool
- The aim is to maintain price stability in the Czech economy in line with the CNB’s inflation target, which has been set at 2 percent since 2010.
- The exchange rate is used to significantly limit the risk of deflation and accelerate the return to a situation where the CNB can again use its standard tool, i.e. interest rates.
- The koruna exchange rate is not a new monetary policy objective; it is a tool being used to fulfil the inflation target.

### Timing and rationale for commencing foreign exchange interventions
- The CNB Bank Board decided to use the exchange rate as a monetary policy tool and to commence foreign exchange interventions on 7 November 2013.
- Rationale:
  - For a small open economy with a long-term excess of liquidity in its banking sector, foreign exchange interventions are a more effective tool for easing monetary conditions than other options.
  - Use of foreign exchange interventions to counter deflation risks was recommended by an IMF mission.
  - The Bank Board decided in autumn 2012 that the koruna exchange rate could serve as an additional tool once the lower bound on interest rates was reached.

### Operational design of the interventions
- The CNB’s Financial Markets Department will purchase foreign currency as needed in accordance with market conditions to achieve the desired easing of monetary conditions as mandated by the Bank Board.
- The CNB will intervene to weaken the koruna so as to maintain the exchange rate of the koruna against the euro close to CZK 27/EUR.
- The commitment is asymmetric (one-sided): the CNB will not allow the koruna to appreciate to levels it would no longer be possible to interpret as “close to CZK 27/EUR”.
- There is no limit on the amount of purchases; as a central bank, the CNB can purchase any amount of foreign currency.
- The Bank Board meets eight times a year to discuss monetary issues and may hold extraordinary meetings in exceptional cases.

### Implications for future evolution of the koruna exchange rate
- The CNB has undertaken to prevent excessive appreciation of the koruna below CZK 27/EUR.
- On the stronger side of CZK 27/EUR the CNB prevents further appreciation by selling koruna and buying euro.
- On the weaker side of CZK 27/EUR the CNB allows the koruna exchange rate to float; exchange-rate levels weaker than CZK 27/EUR will be determined by supply and demand on the interbank foreign exchange market.
- The Bank Board may change the maintained level at subsequent monetary policy meetings based on the macroeconomic forecast or an assessment of risks; any change would likely require a much stronger impulse than in the case of interest rates.
- As stated in the CNB Bank Board statement published after the monetary policy meeting on 6 February 2014, the Bank Board foresees the present exchange rate commitment being maintained at least until the start of 2015.

### Expected economic effects on households, businesses, and the economy
- A weakening of the koruna exchange rate leads to an increase in import prices and thus in the domestic price level.
- To a lesser extent, a weaker koruna boosts domestic economic activity.
- The rise in import prices can reduce households’ purchasing power, but:
  - Households’ demand may be redirected towards domestic goods and services.
  - Lower real interest rates resulting from higher inflation expectations may additionally support demand.
- The weaker exchange rate supports Czech exports, corporate profitability, and willingness to invest.
- Recovery in production is expected to contribute to a rise in employment and wages, increasing households’ purchasing power.

### Comparison with past interventions
- The CNB last intervened in 2002.
- Differences between 2002 interventions and current interventions:
  - 2002 interventions aimed to prevent tightening of monetary conditions and reduce high volatility of the koruna in a situation of non-zero interest rates.
  - Current interventions are solely to ease monetary conditions through the exchange rate and to hit the 2 percent inflation target when interest rates have reached their technical limit (technical zero) and cannot be reduced further.

### Conditions and announcement of discontinuation
- The CNB is resolved to intervene on the FX market in such volumes and for such duration as needed to hit its inflation target.
- Use of the exchange rate as a monetary policy tool will be discontinued when it becomes necessary to tighten monetary policy significantly as a result of very substantial inflation pressures.
- Discontinuation will be achieved by stopping interventions and then raising interest rates above (technical) zero.
- The discontinuation will be announced after the Bank Board makes the relevant monetary policy decision, in a similar manner as its commencement.
- The need for easy monetary policy can be expected to last for a long time.

### Further clarification from the November 2013 Inflation Report
- Context: Global central banks used extraordinary instruments during the global financial and economic crisis (examples cited: asset purchases, massive liquidity provision, and the Swiss minimum exchange rate against the euro).
- The CNB lowered key interest rates to technical zero in autumn 2012; further easing was necessary given macroeconomic developments.
- Exchange rate chosen because weakening the koruna is effective in a small open economy for raising import prices, stabilising inflation expectations close to the 2 percent target, and, to a lesser extent, boosting domestic activity.
- CNB analyses indicate exchange-rate impacts can be stronger than usual when the koruna is used as a systematic monetary policy instrument at the zero lower bound on interest rates.
- Alternative scenario in the Inflation Report:
  - Recognizes the scope for lowering monetary policy rates was exhausted on reaching technical zero (0.05 percent).
  - States it is impossible to lower 3M PRIBOR market interest rates below technical zero plus the risk premium between PRIBOR rates and the 2W repo rate.
  - In the alternative scenario, the exchange rate takes over the stabilizing role of monetary policy.
  - Exchange rate weakening to CZK 27/EUR accelerates the return of inflation towards the 2 percent target and allows for an earlier exit from the zero lower bound on monetary policy interest rates.
  - The Bank Board may assess this forecast scenario from the perspective of perceived risks and take this into account in deciding on the necessary exchange rate weakening.
  - “The level close to which the CNB will maintain the exchange rate will be publicly announced on the day the decision is made.”

*Source: Appendix I. Selected Q&As from CNB web site in November 2013 (from the supplied document).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp1574.pdf_