Minutes of the Bank Board Meeting on 26 October 1998

Present at the meeting: Josef Tošovský (Governor), Jan Vít (Vice-Governor), Miroslav Hrnčíř (Chief Executive Director), Ota Kaftan (Chief Executive Director), Jiří Pospíšil (Chief Executive Director)

The board assessed the short- and medium-term inflation outlook in the context of the newly available September data. By the end of 1998, net inflation should be significantly below the lower bounds of the target interval. In the first half of 1999, net inflation will most likely experience a temporary slowdown. In the second half of the year, net inflation will return to the disinflation trajectory implied by the medium-term target for the year 2000.

During the discussion, many reasons were given for this shifting development. Net inflation was strongly affected by an external shock, notably a drop in the world prices of some imported commodities which in turn led to an acceleration of the disinflation process. The combined effects of the positive price demand shock with fiscal and wage developments, in reality more restrictive than expected at the beginning of the year, had set in. Due to significant uncertainty stemming from international financial developments, it was difficult to avoid a cumulation of factors acting in the same direction during decisions on monetary policy measures. The rate of the disinflation process can be classified ex post as fairly rapid.

In addition, the bank board analysed the international economic outlook for 1999. International factors will play a significant role in monetary policy decision-making next year as well. In all probability, there will be a drop in international economic activity. Financial developments could be affected by a cut in US interest rates and in turn by a relative cut in European rates (in connection to Euro introduction), because rates will converge to the lower boundary instead of the originally expected convergence to the medial values of European interest rates. After the introduction of the Euro, the koruna could become one of the alternative currencies. As a result, increased uncertainty about the future of exchange rate developments must be taken into consideration, because a strong inflow of capital or worsening of the indicators for the current account causing a reverse outflow effect cannot be ruled out.

The bank board assessed the current risk factors influencing the Czech economy. Substantial uncertainty exists in relation to wage and fiscal developments for next year. The likelihood of lowering this uncertainty in the area of wages is significantly higher than last year considering that consistency in inflation and wages had not been attained last year due to objective reasons, mainly time inconsistencies. During the meeting, a consensus was reached on initiating informative meetings with professional and labour organisations with the aim of creating conditions for long-term economic stability. A favourable situation would be if wage negotiations could be integrated into the framework of a realistic inflation outlook with the possibility of using inflation clauses.

It was stressed that the inflation target for the year 2000 is so far the only valid medium-term economic target announced for the Czech economy. Uncertainty on fiscal development could be lowered by the government's medium-term economic outlook for this area. Lowering uncertainty would help the central bank arrive at an optimal disinflation trajectory, because monetary policy would not react to economic development in isolation.

Opinions during the meeting on the assessment of the proposal for cutting rates were presented from two points of view. First of all, with the expected development in 1999, a cut in rates was evaluated as a reaction to the shifting inflation outlook. This problem should be partially solved through the accommodation of the positive price shock to the disinflation trajectory and partially through sharp rate cuts in advance. Due to a drop in net inflation to low values in the first half of the year, it is important to prevent sharp increases in real rates even though the annual inflation outlook coincides with the disinflationary trajectory.

The central bank should guard against sharp deviations or a reversal in inflation. The proposed solution can prevent rates from being lowered in a period when it might be necessary to respond to developments in the second half of 1999. The risks of this solution in comparison to a slower lowering of rates reside more in the uncertainty on fiscal and wage developments of domestic factors (public finance, real wages) than in external factors. These risks cannot be lowered by making the inflation outlook more accurate. The active involvement of the central bank should help in lowering the uncertainty.

The proposal was also assessed in a backward-looking manner as a completed maneuvre of rate landing at the level attained before the May 1997 turbulence. Landing occurred at a higher level of ex ante real rates in a period of economic recession and for this reason, it does not entail monetary policy easing. Further space could be created for cutting rates if wage negotiations are consistent with the central bank's inflation outlook. The opposite situation, though, would create dangerous overshooting of monetary policy easing. Following a sharp cut in rates, there are two anti-inflation safety valves: prudent behaviour on the part of banks and the possibility of an expected real increase in household incomes.

After assessment of the economic outlook, the CNB Board unanimously decided to cut the 2W repo rate by 1 percentage point from 13.5 to 12.5%, to cut the discount rate by 1.5 percentage points from 11.5 to 10% and the Lombard rate by 1 percentage point from 16 to 15% effective 27 October 1998. In addition, the introduction of an O/N deposit facility was approved and will take effect 1 December 1998. This involves monetary and technical measures which are aimed at simplifying the management of the liquidity of financial market participants and at gradually harmonising CNB instruments with the instruments of the ECB.