Česká národní banka

Minutes of the Bank Board Meeting on 29 July 1999

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

The Bank Board opened the meeting with a discussion of the new economic projection which takes into account the new data from the second quarter. It was stated that the inflation forecast corresponds to the medium-term inflation target for the year 2000, though, pointing more towards the lower border of the target. The forecast falls below the target for 1999. The Bank Board assessed the effect of individual factors on the inflation forecast and considered lowering rates as a possible response to expected developments.

One reason for proposing a cut in rates was the fact that the new inflation forecast clearly indicates achievement of the inflation target for 2000. This forecast was created on the basis of expected developments in the domestic and foreign economy, which, according to the baseline scenario, do not show any significant inflationary impulses. Lowering rates, nonetheless, was not considered as a response to deviations in the 1999 forecast. Monetary policy must respond to expected developments in advance, in order to reflect a time lag in monetary transmission. Monetary transmission takes longer than half a year, and, therefore, inflation in the second half of 1999 is influenced more by external factors than by monetary policy settings. The prices of some commodities and food prices on the domestic and foreign market were two specific external factors mentioned. A positive price shock has appeared in food prices. Hence, compensating with monetary instruments would be too costly in the short run and would cause high volatility in the other variables.

The gap between supply and demand was indicated as a significant factor in assessing the economic situation. Estimating the gap is a difficult task, even in more advanced economies. Application of various methods, whether it be the production function or smoothing by means of filters, is a very demanding process in the Czech Republic. In spite of this difficulty, an information base is being developed at the Czech National Bank to deal with this particular area. Several views were expressed during the discussion concerning the nature of the gap between supply and demand. The current inflation projection is based on the assumption that the gap is significant and that demand recovery, which some indicators have already suggested, will mainly cause a rise in GDP and not in prices. On the other hand, it was argued that the supply side could be relatively inflexible, causing strong demand recovery to surface more as a rise in prices or a rise in the external imbalance and less as GDP growth recovery.

It was mentioned that the inflation projection accounts for the expectation that the Czech economy will enter a phase of non-debt capital inflow (FDI, portfolio investment). In one or two years, this inflow could produce a stronger Czech koruna. The Bank Board discussed whether this expectation should be reflected in monetary policy decision-making, and if so, how it would be reflected. It was stated that in a period of exchange rate appreciation, it would be possible to use rate cuts to compensate for the exogenous tightening of monetary conditions. The setting of monetary conditions should essentially be derived from the difference between the inflation outlook and the inflation target. The direct aim of lowering rates is not to influence the exchange rate, even though some forms of capital inflow are sensitive to the interest rate differential. It was also mentioned that non-debt capital inflow alone could alleviate the problem of exchange rate appreciation, because foreign investment contributes to productivity growth.

The board members also discussed the risk factors that could possibly cause the current economic projection to underestimate inflation developments in the medium term. In addition to fiscal factors, a rise in real incomes, if the level of household savings falls, could also contribute to stronger demand recovery than with the current projection. Money supply growth could also contribute to stronger demand recovery. Attention was given to interpreting the difference between the money supply and domestic credit issues.

At the end of the discussion, the Bank Board decided by a majority vote to lower the CNB two-week repo rate from 6.5% to 6.25% (by 0.25 percentage points), effective 30 July 1999.

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

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