Minutes of the Bank Board Meeting of 13 August 1998

The following members of the Board were present: Pavel Kysilka (Vice-Governor), Jan Vít (Vice-Governor), Miroslav Hrnčíř (Chief Executive Director), Otta Kaftan (Chief Executive Director), Luděk Niedermayer (Chief Executive Director), Jiří Pospíšil (Chief Executive Director).

At the meeting the CNB Board assessed newly available economic information and characterised the starting situation for monetary policy in the forthcoming period. The latest information on the real economy, in particular the unemployment data, had confirmed the trend of curbed domestic demand. This had created space for interest rate cuts. The development in regulated prices and net inflation in July had also provided a favourable signal. The change in rates, along with reduced inflationary expectations, should feed through into investment decisions in particular. The favourable trend initiated at the microeconomic level could be slowed down by a signalised easing of budgetary restraint in the public sector and by the consequences of this, for example in a return to divergence between wage growth and labour productivity growth.

The Board concluded that the Czech financial markets could be affected in the next period by strong capital flows in both directions. Should the region stabilise successfully, a relatively strong inflow of capital with various maturities could be expected, with a volume similar to that seen in 1995. The impacts of the Russian crisis had indicated that it might be also necessary to reckon with short-term capital outflows. These features imply that the economic decisions will face larger exchange rate uncertainty and that it will be an important role for financial markets to help the domestic economy adapting to the new situation.

The present capital inflow and the interaction between capital flows and the exchange rate were being determined both by domestic and external factors. The successfully started disinflationary process had reduced inflationary expectations and the risk premium. The risk premium had also been relatively low due to external factors since relatively well-developed Czech financial markets were allowing investors to re-orient fast to the koruna in the cases of sudden deterioration of the situation in other countries of the region.

The Board characterised two transmission channels of fiscal policy. First, public deficit/surplus influences economic development. If public sector performance, including off-budget funds, were to send out inflationary stimuli, the parameters of monetary policy would have to be changed in the medium-term. The second channel concerns expectations. A change in government strategy of imposing a hard budget constraint on the economy could, through this channel, affect the risk premium.

The Board defined three stages of inflation development. At the end of 1997, the Czech economy had entered a stage of accelerating inflationary expectations. In this stage, the main tasks of monetary policy had been to provide the economy with a nominal anchor and to prevent inflation from escalating. The end of the first half of 1998 had brought a transition to a second stage. Inflation had reached levels corresponding to those seen before the period of exchange rate turbulence in May 1997. Monetary policy was focused on a disinflationary process which would gradually bring inflation below the level seen in previous stages. This stage was characterised by a decline in inflationary expectations with a subsequent reaction from the financial markets, and was bringing new types of problems for monetary policy calibration. Specifically, a potential volatility of inflation indicators could become a serious problem. If economic players do not accommodate to conditions of the second stage, their delayed response could spell a return to excessive growth in real wages. Prospectively, a transition to a third stage of very slow desinflation could be expected that would correspond in its characteristics to standard strategy of inflation targeting with horizontal band.

The Board considered a proposal of lowering the Lombard, discount and two-week repo rates. It stated that this was an important monetary policy decision which would change the parameters of monetary policy so that they correspond to features of the above-characterised second stage. With lowered rates, the inflation outlook derived from important economic indicators would be consistent with the targeted disinflation trajectory. The suggested scope of changes to monetary policy parameters corresponded to usual uncertainty in the inflation outlook implied by including expected risk factor values without extreme deviations. It was mentioned that should these factors deviate extremely (a possibility which could not be excluded but which was relatively unlikely), it would be necessary to consider a modification of adopted measures. The Board emphasised that calibrating the measures according to the medium-term inflation outlook with the possibility of a correction in the case of a difficult-to-predict shock was a standard monetary policy procedure. In the end of the meeting, the Board decided unanimously to cut the two-week repo rate from 14.5 to 14%, the discount rate from 13 to 11.5% and the Lombard rate from 19 to 16%, effective 14 August 1998.