Česká národní banka

Minutes of the Bank Board Meeting on 4 October 1999

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

At its regular meeting, the CNB Board assessed the monetary implications of the most important changes that had taken place in the Czech economy and in the external environment since the last meeting on economic and monetary developments.

The Board noted that the Czech Statistical Office's estimate of GDP for Q4 1999 revealed signs of economic recovery - year-on-year, as well as quarterly seasonally adjusted growth. The driving force behind this improvement in economic performance was more favourable developments in net export and private consumption. Trade balance results for August confirmed the positive effect of the external sector on GDP growth.

The sustainability of economic recovery, the extent of which enters into the inflation forecast when assessing future demand inflation pressures, is to a certain extent connected to positive developments in the external sector. In the light of this relationship, the Bank Board indicated as a risk factor any sharp appreciation of the koruna that would threaten the inflation target for the year 2000. The direct impact of koruna strengthening on net inflation and inflation expectations could possibly increase the likelihood of missing the inflation target.

Identifying the root causes of koruna appreciation was indicated by the Board as a necessary condition for the formation of an optimal central bank response to these developments. It was mentioned that the balance of payments results and information from the market had shown that the presence of short-term capital motivated by the interest rate differential was not a source of appreciation pressure. In view of the positive outlook for stronger inflow of foreign direct investment, koruna appreciation was most probably caused by a market that was, in fact, anticipating the appreciation of the koruna. Hence, the Board remarked that, in relation to the high uncertainty concerning the volume, time distribution and manner in which these expected investments would be financed, the central bank, as well as market agents, were faced with difficulties in quantifying the degree of future appreciation pressure. As a result, the market response could, in certain cases, be overestimated. The Board expressed their intentions to intervene in order to prevent the excessive appreciation of the koruna, which over time could be unsustainable, and in the short-term, inconsistent with the CNB's inflation targets. The Board also stated that the CNB did not observe capital inflow motivated by the interest rate differential and that it was not limited to its current foreign exchange reserves when intervening to weaken the koruna. It was also stressed that the central bank would employ a combination of different instruments in its strategy, including efforts to carefully coordinate monetary and fiscal policy.

The Board wanted to make clear that the CNB's decision to intervene did not represent a change in its monetary policy aims. In an inflation-targeting regime, guarding against extreme exchange rate volatility is desirable in view of how quickly import prices affect net inflation. This is especially true when there is a risk of unsustainable developments. Any sharp depreciation of the koruna as a response to unsustainable appreciation would have serious monetary and macroeconomic implications. Contrary to the direct impact of a nominal exchange rate change, which is not related directly to the interest rate differential, the impact of the interest rate change on the transmission mechanism is characterised by a longer time lag. As a result, short-term interest rate cuts may not be sufficient for attaining the inflation target. The continuing problems on the supply side of the credit market had been caused by microeconomic and structural deficiencies in the Czech economy as well as the nature of capital inflow. In view of the problems facing the credit market, the Board maintained that foreign exchange intervention, in spite of its limitations, could be a more effective instrument in reaching the inflation target than, for example, larger changes in short-term interest rates.

The importance of the level of real interest rates in assessing monetary policy settings was emphasised during the meeting. It was mentioned as a reminder that even with existing uncertainties concerning the market's inflation expectations, it could be said that real interest rates measured by the PPI in a horizon of more than twelve months were, in principle, consistent with the level achieved in the economic cycle.

Current money supply dynamics, wages, and external cost and demand factors were examined during the discussion, and overall developments in these segments were believed to correspond to future targets in the monetary area. In assessing these factors, the Board did not identify any strong risk of imbalance in the short run.

Public finance performance was considered to be a growing source of uncertainty when implementing monetary policy in the medium term primarily owing to difficulties in quantifying the volume and time scheduling for the use of privatisation revenues. Hence, a concern was raised that the budget deficit for the year 2000 might be larger. Using privatisation revenues for financing government off-balance sheet expenditures was one of the concrete risks mentioned.

The CNB Board unanimously decided to intervene in the foreign exchange market in order to weaken the koruna. The Board also decided, by a majority vote, to support this action by lowering the two-week repo rate from 6% to 5.75%, effective 5 October 1999.

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

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