Minutes of the Board Meeting on 28 May 1998

The Board reviewed factors that would have an impact on inflation in the short as well as medium run. The continuation of low monthly price dynamics was evaluated as an important positive signal. During the discussion, it was said that monthly inflation had been depressed by the exchange rate's low volatility and favourable conditions on international markets with raw materials. It was also mentioned that both factors should be viewed as temporary. Due to a slowdown in inflation, uncertainty on domestic financial markets was reduced and interest spreads fell. However, the sensitive reaction of domestic markets to recent news about developments in Russia demonstrated clearly that the gained stability was fragile.

The economic trends in the first five months of 1998 confirmed that there were positive signals on the real economy side. Consumption as well as retail sales grew more slowly. In order to prevent a negative reversal in these trends, it was stated that wage increases should not exceed productivity gains. The balance of payments data signalled that the stabilisation process was continuing. Some risk factors were identified for the medium-run outlook. The probable impact of external sector development in the Slovak Republic on the domestic trade balance was discussed.

The Board agreed that the ratio of the current account deficit to GDP was significantly reduced and was below the level usually used as a warning indicator. Nevertheless, the risks of reoccurrence of a larger deficit were mentioned together with implications for sustainability of foreign indebtedness. The concern was expressed that the domestic economy should not excessively borrow abroad. The potential for worsening borrowing conditions on international financial markets was taken into account, since foreign investors could change their investment strategies towards emerging markets after the Asian crisis. Investors could also be influenced by estimations of the impact of transition on the domestic banking sector.

The Board emphasised the role of foreign direct investment which should have a stabilising effect on various types of capital transactions. The volume of foreign direct investment was compared to recent numbers in the current account deficit. According to May data, there was a downward trend in volumes of investment, and the structure was less favourable due to a fall of the share of green field investment projects in the total volume of foreign direct investment. The weakened inflow of relatively stable capital was expected to strengthen again in the medium run if recent improvements in the investment environment were reflected in investment decisions.

The situation on domestic financial markets was discussed next. Markets were efficient and performed their regulating role. During periods of short-term capital inflows, the exchange rate appreciated and short-term interest rates decreased. For maturities up to six months, the reaction of markets was significant. Due to exogenous shocks such as important political news, the volatility of the exchange rate remained high and the short-term equilibrium level to which market converged during trading changed often. This feature of the foreign exchange market was an important factor in making monetary policy decisions. The Czech National Bank would not intervene on the foreign exchange market to keep the nominal rate close to a certain level. The Bank, however, would intervene with the aim of smoothing exchange rate movements that were a reaction to an exogenous shock and to a subsequent change in the short-run equilibrium trading level.

The Board carefully examined the expected impact of fiscal policy on the economy. In May, the magnitude of the projected budget deficit was significantly higher than assumed at the end of 1997 when the Bank announced its inflation target. Should this trend continue in the second half of 1998, concern was articulated that an additional inflation impulse might be sent to the economy. The question of what the consequences of transforming a hidden fiscal debt into securities would be for domestic financial markets was considered in this context. The improvement of fiscal transparency was assessed as a very positive factor that would increase the efficiency of financial resource allocation in the economy.

The Board evaluated the January experience with the impact of changes in regulated prices on net inflation. It was concluded that the secondary inflation impulse that was sent from the category of regulated prices to prices included in the index of net inflation was unexpectedly high and was underestimated by the 1997 analysis. However, this higher-than-expected impact on net inflation was compensated with very favourable conditions on the foreign exchange market. It was argued that the July changes in regulated prices would have a different impact on net inflation, since the composition of prices, presumably subject to changes, should be different from January's. Consequently, the impact on net inflation would be smaller due to an income effect.

After discussion of short-term and medium-term factors that influence net inflation, the Board unanimously decided to leave interest rates unchanged. The Board agreed that available information on inflation was favourable and short-term factors forming inflation did not signal that the 1998 target for net inflation would fall short of its goal. However, the medium-term factors when analysed showed several potential risks that could cause net inflation to overshoot the target if an adequate policy reaction is not adopted. Since, according to a likely scenario, all the potential risk factors would not materialise, the strategy to leave the rates unchanged was evaluated as consistent with the medium-term target for net inflation.