Minutes of the Board Meeting on 31 January 2002

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

The presentation of the 1st situational report on economic and monetary development was based on the new economic forecast for the period 2002 to 2003. It was said that the Monetary Department had made downward adjustments in the inflation forecast and GDP growth forecast - in comparison with the forecast from October 2001 - for the range of the most effective monetary transmission. During 2002, inflation would decline until June, at which time it would temporarily stray from the targeted band due to technical factors. From June to the end of 2002, inflation would pick up momentum and then return to the lower half of the band. The forecast risks mainly involved the effects of slow recovery in Germany, the strong exchange rate, and underestimating the downward flexibility of prices. The risks accompanying the inflation forecast were, therefore, asymmetric - with more weight on the anti-inflationary side.

The presentation also contained more detailed analyses of the specific areas of the economy from which the forecast was derived. Growth in domestic aggregate demand was expected to be in a range of 3% to 4% in 2002 and 4% to 5% in 2003. The negative output gap would gradually close up in 2003. Inflation would be pushed towards the lower boundary of the targeted band thanks to the strong anti-inflationary effect of external factors. Adjusted inflation would slightly rise. The inflation forecast operated under the assumption of substantial downward price rigidity. If prices were flexible, the resulting inflation could be lower than the forecast indicated. Slowing M1 and M2 growth would signal a potential slowdown in economic growth. However, a recovery in credit issue was taking place, and if confirmed by current dynamics, this could mean a return to the standard observed in similar European economies. The fiscal impulse was somewhat neutral in comparison with the original expectations in 2001.

The presentation of the 1st situational report was followed by a discussion on the new economic outlook. Several views stressed that the outlook was realistic and that the situational report provided a number of arguments in favour of lowering rates. However, it was repeatedly stated that the risks of the current forecast were not concentrated on the anti-inflationary side alone, especially from the viewpoint of domestic factors. Expected domestic demand growth was relatively strong. The monetary aggregates were increasing at a higher rate than nominal GDP. Fiscal policy had eased up, and credit growth was once again recovering. In all probability, the world would experience economic recovery in 2003. Commodity prices could also rise on international markets. In the range of the most effective transmission, the macroeconomic framework would be too loose, and inflation would fluctuate more towards the upper boundary of the targeted band.

In this respect, the Board discussed the current level of interest rates. It was said that interest rates were at an historical long-term low in absolute terms. Nevertheless, it was mentioned that this level was consistent with the new economic outlook, provided that the output gap would be closing up during 2003. It was also expressed that the interest rate level was to some extent inherited from the past, i.e. low rates corresponded to conditions of very low growth, and was in part compensation for tightening overall monetary conditions due to the strong koruna exchange rate. Some board members also expressed that maintaining the current level of rates was an adequate reaction in view of the risks of loosening the macroeconomic framework.

Attention was focused on the effect of the agreement concluded with the Government to handle the exchange rate effects of state incomes on the strengthening koruna. There was consensus that the agreement had a high potential for alleviating pressure on the koruna, but that markets would only evaluate its significance over time.

The Board also focused its discussion on the inflation forecast for the whole period of monetary transmission. It was expressed that inflation's signalled short-term deviation from the targeted band during 2002 was a reflection of technical factors relating to the CPI in 2001 and not a result of monetary restriction. Moreover, inflation was pushed towards the lower boundary of the targeted band by external factors. It was also mentioned that the technical deviation from the band was not cause for implementing monetary policy measures. When considering the length of monetary transmission, completely eliminating the technical deviations would be too costly in view of the volatility of important economic variables. Other views expressed that a change in interest rates - though not a perfect substitute for the exchange rate - could be used to ease monetary conditions. These monetary conditions were not only tightened by the effect of the strengthening koruna, but also by the effect of falling inflation expectations.

Following the discussion of the January situational report, the Board decided, by a vote of three to two, to lower the CNB two-week repo rate by 0.25 percentage points to 4.25% and to lower the discount and Lombard rates by 0.25 percentage points to 3.25% and 5.25%, respectively, effective 1 February 2002. Two board members voted in favour of leaving the rates at their current levels.

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

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