Minutes of the Bank Board Meeting on 26 July 2001

Present at the meeting: Oldřich Dědek (Vice-Governor), Luděk Niedermayer (Vice-Governor), Michaela Erbenová (Chief Executive Director), Jan Frait (Chief Executive Director), Pavel Racocha (Chief Executive Director), Pavel Štěpánek (Chief Executive Director), Jiří Rusnok (Minister of Finance)

The meeting opened with a presentation of the 7th situational report on monetary and economic development. The presentation was centred on the new quarterly forecast of macroeconomic development and the implications of the revised macroeconomic outlook for monetary policy. There was a change in the assumptions for exogenous variables. The forecast was based on the assumption of slightly higher import prices and a lower economic growth rate in Europe. In addition, a revision of the national accounts and GDP data was assessed, and the change in the employment trend had been taken into account. The Czech Republic was apparently entering a new phase in which potential product growth was faster than in the past. The role of household consumption was reassessed. According to new figures, this is clearly an item that contributed to GDP growth. According to previous data, though, consumption had not been a dominant factor. Because of the change in the assumption on potential product growth, the higher growth rate in the projection had not caused any deterioration in the external imbalance. This conclusion corresponded to information reflecting the declining propensity to import out of GDP. The basic decomposition of prices was similar to that in the April forecast. For the time being, inflation had mainly been cost-based in nature, and an important role was played by food prices. With the current phase of the economic cycle, cost pressures would gradually give way to demand pressures. In view of the revision of the macroeconomic framework, there was an upward shift in the inflation and growth projections. The inflation forecast had shown a slight break in the trend during mid-2002 and, for a part of this period, would exceed the upper boundary of the targeted band. The break in the inflation projection' s trend and its return to the band was conditioned by the assumption of small-scale deregulation, slower food price growth and stable inflation expectations. However, the risks presented by the forecast had accumulated on the inflation side. Inflation expectations could accelerate. An expansive macroeconomic environment might facilitate the transfer of pressures to prices more rapidly.

The Board followed up the presentation of the 7th situational report with a discussion of the macroeconomic outlook. It was mentioned that both expert and model projections had made similar reassessments of the macroeconomic outlook reflecting the Czech economy's higher performance. The projections also confirmed fears about the inadequate setting of interest rates expressed during the meeting in June. The economy was growing faster than had been expected at the beginning of the year, and the inflation forecast was higher. In this respect, it was expressed that present inflation had been predominately cost-based in nature, or core inflation was lower. The main reason for increasing the rates was the uncertainty connected with how quickly cost pressures would spill over to demand pressures and inflation expectations in an environment of economic growth, a closing output gap and an expansive fiscal framework. A view was put forth that current price growth, including a rise in food prices, could already be a certain reflection of higher demand.

The Board agreed that the risks connected to the expert forecasts would accumulate on the inflation side. It was added that a rise in the money supply and the fiscal deficit could send a stronger demand impulse than had been considered so far, which could cause foreign demand to be substituted by domestic demand. Inflation expectations and the impact of its acceleration on wages were discussed. It was mentioned that monetary policy must be pre-emptive when responding to a potential increase in expectations, since repetitive disinflation would be costly. Members also discussed the issue of flexible monetary policy instruments, the extent of rate increases and breaking down a potentially larger change into smaller steps.

The Board devoted a part of their discussion to the revision of data on GDP and the national accounts. Overall, it was expressed that the revision of data changes the macroeconomic outlook and that it increases uncertainty during decision-making. The revised data on consumption was now beginning to correspond with previously available indicators of a declining savings rate. The revised data indicated that higher consumer demand growth might be consistent with lower inflation. Because of the inconsistency of the revised time series, however, no sufficient evidence was available to confirm this theory. Food price development was also a topic of discussion. Modelling food price development was not only complicated by high volatility, but also by uncertainty related to the effect of food price convergence.

At the close of the meeting, the Board decided unanimously to raise the CNB two-week repo rate by 0.25 percentage points to 5.25%, and accordingly, to increase the discount and Lombard rates by 0.25 percentage points to 4.25% and 6.25% respectively, effective 27 July 2001.

Author of the Minutes: Kateřina Šmídková, CNB, Adviser to the Board

Comments are welcome on the following email address:Katerina.Smidkova@cnb.cz