Minutes of the Bank Board Meeting on 25 May 2000

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

The Board said that this year's inflation forecast suggested undershooting of the inflation target. In respect to the time lag of the transmission mechanism, monetary policy's targeted horizon had been gradually shifting into the first half of 2001. When assessing monetary policy settings for the time horizon beyond December 2000, the consistency of the inflation forecast and inflation target for indicated that monetary policy instruments would have a neutral effect.

Available data had shown that a wide range of sectors in the economy were experiencing economic recovery (industry, construction and services). Wages in industry had registered substantial growth, and a rise in the wage dynamics in some areas of the public sector had also not been ruled out. In the previous period, some indicators had not confirmed acceleration in the recovery process, particularly VAT collection and retail sales. The latest data on export dynamics also contributed to this view. However, this involved short-term information on variables with a higher level of volatility. A main obstacle to stronger GDP growth continued to be the supply side of the economy, especially the institutional area.

The Board intensively discussed the development of oil and petroleum prices during the past few weeks and the implications it would have for future price development and inflation expectations. After a certain period of decline in the prices of oil and natural gas, these prices started accelerating once again, primarily as a result of institutional factors. Therefore, contrary to original assumptions, a longer lasting inflationary effect with higher price growth for these commodities cannot be ruled out. There was a higher risk that the secondary inflationary effect of fuel price growth on the other items in the consumer basket would strengthen. Widespread publicity on rising fuel prices intensifies the risk of increasing inflation expectations.

A considerable amount of attention was given to assessing expected agricultural producer prices. In discussing domestic price-creation factors, it was noted that most primary producers conclude long-term contracts. For this reason, prices would more than likely be rigid in the short run. It was stressed that even though for the first time this year "green petrol" could be taken advantage of more extensively, costs for agricultural production had not been reduced - in spite of original expectations. Therefore, pressure on rising food prices would most likely be caused by increased costs for food processing and product distribution. Contract renegotiations and, in turn, a rise in prices would not be anticipated sooner than next year. During a discussion on the main external factors affecting domestic food prices, it was stressed that a substantial drop in food prices on European markets had occurred after the Russian economic crisis. The subsequent decline in demand for food in Europe caused a sharp decline in prices. With the gradual improvement of the Russian economy, supported by the strong fiscal stimulus of high oil prices on world markets, increased demand for food products could be expected. In this context, economic recovery in Russia could in the short run have a more significant role in the development of food prices than the impact of unfavourable climatic conditions or commodity price growth.

An analysis of the CPI structure suggested that there were substantial differences in the segments of the consumer basket, especially between tradables and non-tradables. In the area of tradable commodities, the price level had not registered any month-on-month changes. After eliminating the effect of fuel prices, the month-on-month price index for this subgroup would be negative. Another important factor for the future structure of prices was the deepening gap between consumer price inflation and net inflation. This development had been caused by institutional changes, mainly higher expected deregulation at the beginning of next year and an increase in the effective rate from VAT. In anticipation of revisions in the consumer basket in July of this year using 1999 as the base year, those price items that experienced above-average growth would be expected in the future to have a higher weight in the CPI.

The money supply indicated that the gap between nominal income and M2 would gradually narrow. Nevertheless, an analysis of the main sources of M2 growth - domestic credits, credits from abroad, financing through foreign direct investment resources - showed that these forms of financing would allow economic recovery to continue.

From the viewpoint of the Czech economy, world economic growth for this year was given a very favourable assessment. Strong growth in the US economy had continued. Growth in Europe and in emerging markets was also accelerating. At the same time, short-term interest rates had also experienced a rising trend, especially in the USA. Rate increases could also be expected in the Eurozone. The interest rate differential continued to narrow vis-à-vis the euro, and the negative interest rate differential vis-à-vis the USD had worsened. The meeting also focused on the situation in Poland, where economic developments, along with emerging political instability, had created a risk-potential environment. The necessity of monitoring further developments in the region was emphasised.

The degree and length of time that it would take for the year-on-year growth of industrial producer prices to show up in net inflation was considered to be one of the most important sources of uncertainty for setting short-term interest rates. While import prices had already significantly influenced growth in industrial producer prices, PPI growth had not yet significantly affected consumer inflation. An estimate of the impact of unfavourable climatic conditions was another strong source of uncertainty, and, in turn, affects the reliability of the inflation forecast.

The Board expressed that, in comparison to the situation a month ago, monetary conditions had eased up, particularly due to weakening of the effective exchange rate. Furthermore, with growing inflation expectations, which were reported in CNB research, real interest rates fell ex ante. Developments in the external area, particularly current and expected short-term interest rate movements, have to a certain extent substituted for the effect of possible domestic interest rate cuts, which could have been motivated by the likelihood of undershooting the inflation target for 2000. Foreign interest rates might have a rising effect on the koruna exchange rate in the future. Monetary policy must be very prudent in this area.

At the close of the meeting, the Board unanimously decided to leave the CNB two-week repo rate at its current level.

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

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