Present at the meeting: Josef Tošovský (Governor), Pavel Kysilka (Vice-Governor), Jan Vít (Vice-Governor), Miroslav Hrnčíř (Chief Executive Director), Ota Kaftan (Chief Executive Director), Luděk Niedermayer (Chief Executive Director), Jiří Pospíšil (Chief Executive Director)

The bank board opened the meeting by assessing the newly available information on economic development. The current situation indicates that the trends of slowing inflation and declining economic activity are still strengthening. A close analysis of the decline in GDP by components shows that the share of household consumption in GDP is no longer declining. Fixed machinery investment has slowed, and construction investment is falling. Nevertheless, about 50% of the decline in GDP can be contributed to changes in stock reserves. This area is traditionally where all of the errors are contained, and for this reason, developments are difficult to interpret. Prices indices in sectors that are relatively open indicate slower growth than in more closed sectors. The yield curve is inverted with a slightly wider spread.

The board meeting primarily addressed the issue of monetary policy strategy for 1999 with the aim of securing the disinflation process as specified by the inflation targets for 1999 and 2000. The board confirmed the positive inflation outlook for 1999. Domestic factors, mainly curbed domestic demand, will probably not cause any inflationary pressures in the economy. From this point of view, the Czech economy has entered a new phase of development characterised by low inflation.

This new development prompted the board to consider steps towards shifting the band for the base rates (discount and Lombard rates) and the repo rate, so that it would correspond to a low inflation environment. Two options were explored: a) lowering the base rates by 2% and the repo rate by 1%, b) lowering the base rates by 3% and the repo rate by 1.5%.

The discussion also focused on inflation risks in 1999. There are two groups of factors that could lead to a reversal in inflation development and cause inflation in 1999 to deviate from the outlook projected in December 1998. The first group includes the response of domestic economic entities to the transition to low inflation. If inflation expectations are not consistent with the positive outlook, inflation impulses will undoubtedly develop in the economy. One occurrence of inconsistency could be wage negotiations based on an over-targeted inflation forecast. An opinion was given that, to a certain extent, this type of inconsistency could be eliminated by the self-regulatory mechanism of the hard budget constraints that corporations face now.

The second group of risk factors is made up of the effects of the external environment that, in the form of a variety of shocks, could affect the domestic economy. The world economic situation in 1998 was driven by extraordinarily favourable price development and a significant fall in commodity prices.

At the present time, it is especially difficult to predict future developments in world price indices. Given the openness of the Czech economy, this particular situation causes increased uncertainty for the 1999 inflation outlook. For similar reasons, it is very difficult to predict developments on financial markets which were shaped in 1998 by the effects of the Russian and Asian crises.

The bank board discussed how the given risks could potentially affect monetary policy strategy in 1999. If any of these risks develop, the central bank would then assess the resulting situation as an exogenous shock.

This, in turn, would increase the likelihood of reverse inflation development in the second half of 1999. In this case, it would be necessary to modify the current inflation outlook in an upward direction. In the case of deviation from the targeted path, an increase in rates would be in order. The bank board agreed that any reversal in development should, however, be relatively slow. It was mentioned that even if a reversal does occur, leaving nominal rates at their original levels could still cause extensive volatility in real rates.

On the basis of the discussion, the CNB Bank Board decided unanimously to lower the two-week repo rate by 1 percentage point from 10.5% to 9.5%, to lower the discount rate by 2.5% percentage points, from 10% to 7.5% and the Lombard rate by 2.5% percentage points from 15% to 12.5%, effective 23 December 1998.

Author of the Minutes: Kateřina Šmídková, CNB, Council of Advisers

Comments are welcome on the following email address: Katerina.Smidkova@cnb.cz