How the Czech National Bank turned a triumph into a debacle: 10 years since the koruna was weakened

In the fall of 2013 the Czech economy was in a sorry state. The last time we had seen decent growth was six years earlier. After the financial crisis came another recession in 2012, and it continued into the following year. The central bank's projections pointed to mild deflation for the coming year, that is, a fall in average prices, provided the Czech National Bank (CNB) did nothing about it.

The CNB could not do anything about it in the standard way, by cutting the interest rate. That had been at 0.05% since November 2012. For long months Governor Singer tried to persuade the rest of the Bank Board to reach for a nonstandard tool: weakening the koruna. At every meeting, though, he was outvoted. It was not until November 7, 2013, that Mojmír Hampl added the decisive vote and the interventions began.

I will admit right away, even as Mojmír's former advisor, that today I would prefer doing nothing in a similar situation. Mild deflation is no greater breach of price stability than mild inflation. But that is a story for another day, and among my colleagues I am in the minority. If a central bank believes that 2% inflation is best, it makes perfect sense for it to try to deliver it. Back then it was also not entirely clear that something like the deflationary spiral of the 1930s could be ruled out.

The interventions were nothing revolutionary

Weakening the koruna had support both in the logic of the inflation target and in the practice of other advanced-country central banks. Most of them did not touch the exchange rate directly, but they swelled their assets in another way: chiefly by buying government bonds. That would not have been sensible in the Czech context, however, because the CNB could have sucked up the entire market.

The interventions worked like this: anyone who wanted to buy koruna got it at a rate of 27 koruna to the euro. The new koruna were created by colleagues in the CNB's financial markets department with the requisite clicks on a keyboard. When the koruna happened to be weaker than 27 to the euro, the CNB did not intervene. In all, by April 2017 the CNB had clicked two trillion new koruna into existence.

Was that money printed, or spent? Technically neither. Certainly not spent, because the CNB got euros for it. Whether it makes or loses money on them depends on how it invests them and when it sells. Nor were those two trillion printed, though that is only a formal distinction: they were clicked. Had they been physically printed and deposited in banks, the result would have been much the same.

Interventions and money printing

And this is exactly where interventions differ from bond purchases, so-called quantitative easing: we really did click new money into existence. When it buys bonds, a central bank merely swaps one form of money (bonds) for another (cash). It is like breaking a thousand-koruna note into 10 hundred-koruna notes: paying with it then gets a little easier. With interventions, by contrast, entirely new koruna come into being; it is not just making change.

That is why interventions have a better chance of doing something to the economy. Quantitative easing apparently had a negligible effect on both inflation and growth. Yet inflation and growth were what these policies were supposed to achieve. With interventions it was meant to work like this: the CNB weakens the koruna, which makes imports more expensive. A weaker koruna also helps exporters, who want to hire more people. A heated-up economy pushes wages up and, in the end, prices.

In economics that last sentence is called the "Phillips curve." Looking at the data, it is not clear whether it is really a causal relationship and whether it works the way central banks want. In practice, the weakening of the koruna had a somewhat weaker effect than the bank expected. Still, with 10 years of hindsight and a series of econometric studies, there is no doubt that the interventions did in the end raise inflation, and growth a little too.

Research on the effects of the interventions

How do we know? The interventions were a natural experiment. We can compare our economy with countries that had no interventions. The so-called synthetic control method lets us estimate how the Czech Republic would hypothetically have developed without them. There are three such studies, and although their results differ slightly from one another, together they confirm that the interventions raised prices (prevented deflation) and modestly revived the economy.

So the interventions did what they were meant to do, even if not as quickly as the CNB expected in the fall of 2013. What is more, the exit from the interventions in April 2017 went unexpectedly smoothly. Until the pandemic arrived, then, we rated this "exchange rate commitment" as a near-total victory. I repeat that this assessment holds for a central bank targeting 2% inflation, which is, however, entirely standard.

What tarnished the legacy of the interventions was the CNB's conduct after 2017, and especially after 2020. As a by-product of the interventions, the CNB hoarded more euros than the world's largest hedge funds. But it refused to invest those euros so that they would earn money over the long run, on the model of Singapore and Norway. The result is a massive loss for the CNB (and hence, in the end, for all of us), which has two sources.

The interventions as a Pyrrhic victory

First, with most of its euros held in what is de facto a checking account, the CNB cannot offset the loss that comes from the koruna's appreciation. When the koruna strengthens, the koruna value of the euros falls. Second, with higher rates it has to pay tens of billions of koruna every quarter to the banks that keep the koruna it clicked into existence on deposit with it. Half of Czech banks' interest income today comes from here. It is not clear how this effortless profit affects banks' willingness to lend to people and firms.

The CNB made its fatal mistake in 2021, when it refused to use the gigantic stock of euros in its checking account to strengthen the koruna and bring inflation down quickly. It is a missed opportunity of catastrophic proportions, one that will go into the central banking textbooks. We now know that the CNB does not treat its inflation target symmetrically. Deviations below the target bother it; high inflation, not so much. We saw the consequence last year, we see it this year, and we will see it in the years to come.

In a nutshell: the interventions served the purpose for which they were launched 10 years ago. But we did not weigh their long-term consequences enough. Perhaps it would have been better back then to pay out the CNB's loss straight to people "from a helicopter." It is not clear how the interventions contributed to the inflation of 2021 to 2023. In any case, thanks to them the CNB could in 2021 have massively strengthened the koruna alongside raising rates. It squandered that option, which is one reason we have had, over the past few years, one of the highest inflation rates in the developed world.