Česká národní banka

Minutes of the Bank Board Meeting on 3 May 1999

Present at the meeting: Josef Tošovský (Governor), Oldřich Dědek (Vice-Governor), Zdeněk Tůma (Vice-Governor), Miroslav Hrnčíř (Chief Executive Director), Luděk Niedermayer (Chief Executive Director), Pavel Racocha (Chief Executive Director), Pavel Štěpánek (Chief Executive Director)

The bank board opened the meeting with an assessment of the current economic and monetary situation. Setting monetary policy instruments in relation to the CNB inflation targets for 1999 and 2000 was the main task at hand. The board stated that keeping these two targets consistent with each other largely depends on how external cost pressures will affect inflation this year. In view of the sharp decline in inflation last year, net inflation should be gradually directed back to the inflation target in the year 2000. CNB's forecast indicates an increase in net inflation at the beginning of next year. Excessive monetary policy easing in order to eliminate the weaker-than-expected or delayed impact of external exogenous factors on inflation could, therefore, produce excessive rises in demand-led inflation pressures, and in turn, threaten the inflation target at the end of the year 2000.

One significant factor affecting the inflation outlook is household savings. On the one hand, the decline in deposit rates, reaching a sensitive level, could possibly prompt households to increase personal consumption. At the same time, this could lead to a partial conversion of resident savings to foreign currencies. On the other hand, one hypothesis was put forward that the rising unemployment rate and the relatively low level of economic activity would ultimately lead to a higher savings level.

The bank board said that this year's state budget performance does not indicate any development of excessive demand-led inflationary impulses. A concern was raised that even with the anticipated strong restrictions on the expenditure side, the state budget deficit would still sharply increase next year. If no adjustments in the planned public budgets occur in 2000, an unfavourable mix of monetary and fiscal policy could surface once again.

The bank board extensively discussed what would be the preferable CNB strategy for dealing with the expected sharp inflow of foreign direct investment this year and in the year 2000. In the short run, the current account deficit cannot correct a financial account surplus of this size. This surplus would lead to potential pressure on the nominal strengthening of the koruna in the future. It was stressed that such excessive tightening of monetary policy is not desirable. Given a neutral interest rate setting, real exchange rate appreciation could be permitted only in the case of a positive difference in labour productivity growth in comparison to the external environment.

It was mentioned during the discussion that in the light of expected exchange-rate development, the central bank should be prepared for more flexible policy in the area of interest rates. With more persistent exchange rate appreciation caused by capital movements on the financial account, other things constant, short-term interest rates would be lowered and vice versa. As a response, it was noted that the optimal CNB reaction to the inflow of foreign resources depends on the character of the capital inflow. Short-term foreign capital motivated by the interest rate differential exists in the Czech Republic at a very limited level only. On the other hand, the interest rate cut supports the inflow of capital into the equity market. Lowering the interest rate differential does not have to significantly affect the inflow of foreign direct investment, but it could lead to the conversion of domestic koruna savings to foreign currencies.

The bank board continued by discussing the impact that cutting short-term interest rates could have through various transmission channels on the segments of the real economy. It was said that cutting interest rates would mean lowering costs of the already existing loans and at the same time lowering the costs of financing new investments. One opposing argument stressed that the results of the internal CNB analysis supports the relatively low share of credit costs in overall costs of the business sector. Therefore, lowering short-term interest rates would more than likely have no serious impact. In addition, no significant credit expansion can be expected due to structural problems of the economy, nor can improvements be anticipated in export companies that in the case of income from exports in foreign currency are financed in those currencies. There is a likelihood that financial markets could interpret lowering short-term interest rates as inflationary, and therefore, they might expect short-term rates to be corrected in the future. This could have a negative effect on the current level of long-term interest rates and in turn lead to a rise in the cost of credit.

In comparison to the cost effects of interest rates, the exchange rate channel has been considered to be significantly more important. In view of the low year-on- year growth of domestic demand and unfavourable development of external demand against last year, a change in the nominal exchange rate, and consequently the real exchange rate, was considered to be an effective stimulus for the Czech economy.

The bank board stated that implementing monetary strategy this year as well as in the year 2000 is complicated by a variety of uncertainties. One problem that is encountered when assessing the level of restriction through real interest rates is the reliability of estimates of expected inflation. Significant uncertainty exists when looking at the future structure of the revenues and expenditures side of state budget, other public sector entries and the easing of regulated prices. Commodity price predictions are traditionally conditioned by a large number of economic and political factors. Agricultural producer prices will be strongly affected by the undergoing domestic structural changes in the sectors of this industry.

The bank board examined the uncertainties linked to the estimation of potential output growth in the Czech economy. A characteristic of macroeconomic developments between 1995 and 1997 was real economic growth exceeding potential growth, as is shown, among others, in the edge that domestic demand had over supply during this period. Without fundamental systemic changes, significant growth in potential output cannot be expected in the Czech economy.

On the basis of the submitted proposal and the discussion that followed, the bank board decided unanimously to cut the CNB 2W repo rate by 0.3 percentage points, effective 4 May 1999.

Author of the Minutes: Tibor Hlédik, CNB, Council of Advisers

Comments are welcome on the following email address: Tibor.Hledik@cnb.cz