(Annex)
October 1999

Measuring the inflation expectations of the financial market is one of the standard analytical approaches of central banks. Its significance is growing, particularly within the monetary policy scheme ensuring from the inflation targeting strategy. Within this scheme, the central bank's decisions regarding monetary policy measures are not based on a single intermediate target (e.g. monetary aggregate), but on a multi-criteria assessment of the current monetary situation using a set of indicators, many of which are financial market indicators. These indicators in general reflect the valuation of various financial assets and expectations of market participants regarding the future trend in financial asset prices in relation to inflation and output. At the same time, they respond directly to changes in market conditions triggered, for example, by monetary policy measures, the latest macroeconomic and monetary indicators, or by the political situation. A major virtue of financial indicators is their timeliness (in comparison, for example, with the inaccuracy and lags with monetary aggregates), as they are available practically without delay.

The objective of measuring inflation expectations is to assess changes in the inflation expectations of the market as a reflection of monetary, or other, policy decisions. The information acquired in this way provides feedback on the effect of monetary policy on inflation and thereby on the fulfilment of the ventral bank's fundamental objective. Information on inflation or other financial market expectations thus constitutes substantial part of multi-criteria decision-making process, facilitating, for example, the correct timing of monetary policy changes. Moreover, such information can assist retrospectively in evaluating whether the measure had the desired effect and whether the market considered it credible.

The quality and informative power of financial indicators is still increasing in line with the gradual development of individual segments of the financial market. In general, however, it is of course not possible to rule out a situation where the indicators, for various reasons, do not correctly reflect the current situation and the future trend (e.g. the exchange rate and interest rates in the Czech republic at the beginning of 1997, the JPY/USD rate, etc.). The reliability of future interest rates, and thus of the derived future trend is strongly dependent on the stability of the financial market as a whole.

The CNB started regular measurement of the inflation expectations of the financial market in May this year. The most liquid segments of the financial market - the interbank deposit market, the interest rate derivatives market and the foreign exchange market - were selected, taking into account the limitations on the informative power of financial indicators (financial market stability, the low liquidity of the government bond market). The circle of entities surveyed was drawn up from participants who trade both on the money and on the capital markets, who are very active at these segments and thus create prices for various market instruments, and who expressed their consent to co-operate with the CNB. In this way, a group of ten analysts was established, five of them domestic participants and five foreigners. Using standardised forms, the CNB conducts a monthly ¹ survey of their predictions for the following selected indicators:

• year-on-year CPI and net inflation for one- and three-year horizon, ²
• 1W PRIBOR and 5Y IRS for a one-and three-year horizon,
• the CZK/EUR exchange rate for a one-and three-year horizon

This information serves primarily for the needs of monetary policy, i.e. what the trend is in inflation expectations and whether these expectations are consistent with CNB projections, and the subsequent real trend. The information is used also for comparison with the financial market expectations acquired indirectly from yield curves and for possible correction of these expectations.

Results of measurement of financial market expectations for the May-September 1999 period
I. Inflation
The average predictions of year-on-year CPI and net inflation by the whole group of analysts consistently envisage both indicators up by approximately by 2,5%-4% against 1999 in the one-year horizon (in the three-year horizon the predictions are slightly lower). In the period under review, these estimates have been declining in nominal terms in line with the decreasing actual inflation outturns. Financial market expectations are broadly in line with the CNB's predictions. The estimates of domestic analysts are around 1%-2% higher than those of foreign analysts.

The main factors affecting the expected inflation trend, according to analysts' comments:

• The rise in oil world prices
• The necessity to complete deregulation; changes in indirect taxes
• Food price inflation
• The revival in domestic demand

II. Interest rates The financial market was expecting a slight decline in the selected interest rates in the one-month horizon, owing to the CNB's monetary policy measures in the area of key interest rates (the repo rate, the Lombard rate and the discount rate) in the period under review. The assessment of the short-term prediction versus reality for May-September 1999 shows that the expectations of analysts were at approximately the same level as the subsequent actual interest rates, while the yield curve was slightly more positive.

In the long-term prediction horizon (one year), most analysts are expecting stable interest rates. However, in both time horizons, the yield curve's positive slope is increasing modestly. This corresponds with the expected inflation pick-up. Comparisons between the predictions of domestic and foreign analysts again show that domestic participants' expectations are around 0.3%-1% higher. Comparing the prediction for the 1Y PRIBOR in the one-year horizon and the current 1Y FW rate reveals that the analysts' projections are 0.16%-0.30% lower than the current market indications. The main factors affecting the interest rate predictions:

• In the short-term horizon - expectations of flat interest rates, since the market does not expect any further changes following the CNB's key rate cuts in the past period.
• In the long-run - expectations of a modest interest rate rise, resulting from the increased need to finance the fiscal deficit, the possible raising of interest rates by the ECB and the pick-up in inflation.

In May and June, the short-term predictions for the koruna´s exchange rate against the euro indicated a stable trend with a modest tendency towards a koruna depreciation. However, based on developments in reality, analysts´ expectations tended towards a stable trend with a short-term appreciation tendency. For the June-September 1999 period, though, the actual nominal exchange rate level was lower than the prediction. The one-year predictions indicate that the koruna will depreciate against the present situation, bur even these values are gradually falling in nominal terms.

The main factors affecting the predictions for the koruna´s exchange rate against the euro:

• In the short-term horizon, the market is expecting stable development, or possibly a slight appreciation, mainly because of the FDI trend.
• In the long-term horizon, certain risks are perceived in the possible growth of the current account deficit (increases in prices of oil and other commodities; renewed domestic demand leading to growth in imports) and in the level of the state budget deficit.

A monthly periodicity was chosen on the basis of recommendations by the majority of the participants, due to the still rather specific situation in the Czech economy in which expectations are currently subject to more frequent change than in advanced countries. The forms are sent to the CNB on the tenth working day of the current month. On the fifteenth working day the CNB announces the aggregate results to all the participants.
² The surveying of a one-year and three-year sliding period is tied to the short-term control and medium-term monetary policy targets within the inflation targeting regime in the Czech Republic. In contrast, we have rejected the option of surveying repeatedly for the same period (e.g. the end of the relevant calendar year). Over time, during the relevant calendar year, such information loses its power, and it becomes no longer possible to respond with monetary policy. The information becomes a mere control item of "how accurately other market participants will hit" the reality at the end of the relevant year.