Minutes of the Board Meeting on 27 June 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), Pavel Racocha (Chief Executive Director), Pavel Štěpánek (Chief Executive Director), Jiří Rusnok (Minister of Finance)

It was confirmed in the 6th situational report that monetary and economic development corresponded overall to the assumptions which led to the Board's decision of 26 April 2002 (a 0.5 p. p. interest rate cut). Predicted year-on-year inflation was headed below the targeted band. A return to the band could be expected during the second half of 2003. As for the weight of pro- and anti-inflationary risks, the mid-point shifted further to the disinflationary side. Exogenous factors were the primary reason for this development: world raw material prices, the exchange rate, especially vis-à-vis the dollar, and a continuation of sluggish global economic recovery.

Following the April interest rate cut, the koruna exchange rate vis-à-vis the euro stabilised for approximately two months and did not react to the new data on inflation, the trade balance, production and sales, or to the election results. When disposing of the foreign currency revenues attained from the privatisation of the gas industry, the CNB and the National Property Fund proceeded according to the Government's decision for resolving the exchange rate effect of capital inflow from privatisation. The negative consequences of the previous rapid koruna appreciation caused the manufacturing industry's financial performance in Q1 to worsen. According to the structure of credit issue, these results presumably also led to further constraints in banks' corporate lending. However in view of the available data, there was not sufficient evidence as of yet that the exchange rate had any significant impact on the competitiveness of exports, employment and wages, overall economic growth and on the external imbalance. The Czech koruna had appreciated again in recent days. Monetary conditions were also tightened again as a result of exchange rate fluctuation and inflation expectations.

Interest rates encountered little change along the whole length of the yield curve. The spread in relation to foreign rates was minimal for long-term and medium-term rates. Low real interest rates contributed to the massive increase in household lending, up year-on-year by one fourth. A significant part of this increase was caused by mortgages. On the other hand, corporate lending to foreign-controlled companies declined.

The slowdown in GDP dynamics for Q1 corresponded to the CNB's forecast, and domestic demand registered satisfactory development. The most recent data on foreign trade (from May of this year) partially corrected the previous, very positive development. The state budget, excluding temporary privatisation income, had worsened in comparison to last year.

In the discussion to follow, the Board confirmed the shift of risks to the disinflationary side owing to exogenous factors. More volatile than internal demand and cost effects, these factors could generate higher uncertainty for the inflation forecasts. This was also reflected in the degree of deviation from the Consensus Forecasts, which are generally used for predicting exogenous factors. It was, therefore, reminded that sharp deviations in world prices or exchange rates were to be classified as escape clauses when targeting inflation.

The Board's discussion centred around the exchange rate developments in recent days, as the Czech koruna appreciated once again against the euro. Certain theories on the cause of this appreciation were discussed. In all probability, the strong koruna was largely related to global developments, which were assessed very negatively by financial markets: particularly, growing uncertainty about the US dollar and American stock markets, the threat of financial crises in specific regions and slow recovery of the world economy. It was mentioned that the current figures on the supply side could indicate the economy's improved resistance to the effects of a strong exchange rate in comparison to previous assumptions. Nevertheless, it was expressed that, although the economy could cope with short-term shocks, constant exchange rate appreciation would lead to changes in the structure of the real economy and, in turn, negatively affect economic growth.

Some board members stressed that the Czech economy's investment wave was dying out, as revealed by import structure changes, a decline in the dynamics of non-privatisation FDI and by developments in corporate lending. Household consumption continued to be dynamic and was supported by transfers from the area of public finances and consumer lending developments. In view of the data on internal economic development, especially domestic demand growth, any additional strong monetary impulse could ultimately threaten the sustainability of economic growth.

On the contrary, it was argued that the risk of inflation remaining below the targeted band had increased and that lowering rates in this particular circumstance would be an adequate response. Weakening of the US dollar vis-à-vis the euro was apparently not a short-term deviation, and import prices were well below last year's level. The elasticity of certain domestic prices had already increased to some extent given the decline in external costs. With the absence of other internal pro-inflationary factors, there was no real reason for inflation to return to the targeted band at a faster rate. Relaxed fiscal policy was a medium-term inflation risk, and its real weight would not be significant enough to offset immediate disinflationary pressures.

There was consensus among board members that the sharp interest rate cut in April proved to be adequate for the current situation and was based on a correct assessment of the risks of future development.

At the close of the meeting, the Board decided by a majority vote to leave the CNB two-week repo rate unchanged at 3.75%. Five board members were in favour of this decision and two voted for lowering interest rates by 0.25 percentage points.

Author of the Minutes: Petr Krejčí, Adviser to the Governor

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