Minutes of the Board Meeting on 25 July 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), Bohuslav Sobotka (Minister of Finance)

The presentation of the 7th situational report opened with an analysis of current economic development. June inflation was lower than the April forecast had predicted. Price fluctuations had slowed in all price segments. The strongest slowdown had occurred in the segments of net inflation, the food segment in particular. However, the prices of non-tradable goods had also shown slower growth. An unexpected sharp drop in import prices and a decline in agricultural producer prices contributed to this deviation. Demand pressures were also more moderate due to slower GDP growth. Growth at this time was mainly supported by consumption. The slowdown in inflation did not constrain wage developments, therefore, real wages rose more than expected. The monetary aggregates corresponded to slower GDP growth and the low-inflation environment.

The July forecast reflected the reality that, in 2002, cost factors would be anti-inflationary in nature and that the slowdown in GDP and foreign demand would curb demand-inflation pressures. Cost factors would be neutral to slightly expansive for the first time in 2003. The output gap in 2003 would close as a result of foreign demand recovery and GDP growth. Regulated prices would also be anti-inflationary, because deregulation was so far lower that predicted in the scenario - a part of the agreement with the Government during their discussion on the inflation target. According to the July forecast, inflation in 2002 would fluctuate below the targeted band and in 2003 would move towards its lower boundary. The July forecast framework brought about a change. The assumption of invariable rates would now be abandoned in the forecast period. The July forecast was consistent with the reduction in monetary policy rates in the second half of 2002 and with increasing these rates in the following period.

The Board followed up the presentation of the 7th situational report with a discussion on the new economic outlook. The Board confirmed that the downward correction in the inflation forecast and growth corresponded with other analyses. A combination of various factors had contributed to the slowdown in GDP growth and the decline in inflation. These factors were described in the situational report. The Board agreed that an appropriate response to the July forecast, which predicted inflation below the targeted band up to 2003, would be to lower rates. It was mentioned that the extent and phasing of this reduction would be an important part of the discussion.

The Board considered a rate cut of 0.75 percentage points as well as dividing this cut into two phases depending on whether or not the new data corresponded to assumptions. It was expressed that a quick and strong response could be needed in view of the unexpected slowdown in inflation, coupled with real wage growth, and the problems associated with the strong currency. Spreading the rate cut over a longer time period would only offset the exogenous tightening of monetary conditions. In support of a lower initial cut, it was said that the combination of an exceptionally large rate change with domestic rates at a lower level than Eurozone rates could send too strong of a signal. In this respect, the exchange rate was also discussed. Some views expressed that the impact of a strong currency was so far not visible in the aggregate data. However, members repeatedly stressed that slower GDP growth was a signal of certain negative exchange rate effects combined with the impact of slowed foreign demand. Figures from the corporate sphere were mixed at this time. Monetary policy would have to respond in advance to lessen the negative impact.

The Board now turned to a discussion of the new framework for generating the inflation forecast. With this framework, the July forecast could be presented to the public as a forecast consistent with certain rate fluctuations. The forecast was based on a model that worked with the simple reaction function of the central bank. This function, in turn, corresponded to the definition of the CNB's target. From an overall perspective, the Board suggested that the new framework was more advantageous. A certain risk related to the transitional phase was also mentioned. In this phase, the correction in the forecast was caused by a combination of changes in the assumptions along with actual changes in the forecasting methodology itself.

The Board discussed the risks of future economic development. It was stated that the rigid development of nominal variables - wages in particular - was one risk involved when inflation unexpectedly slowed down. This factor along with a rise in real rates could worsen the financial situation of companies and work in an anti-inflationary direction. However, a temporary increase in real wages could prompt the acceleration of private consumption, so the final effect may not be clearly quantified. In this context, members expressed that wage bargaining in November should take into account the existing low-inflationary development. The impact of wage momentum would then only be temporary. A possible reverse in exchange rate developments was indicated as another risk. For the time being, though, appreciation was perceived as a more enduring shock. It was repeatedly stated that the current lack of information in the fiscal area was a risk for the economic outlook.

Following the discussion of the July situational report, the Board decided, effective 26 July 2002, to lower the CNB two-week repo rate by 0.75 percentage points to 3.00%. The discount and Lombard rates were also decreased by 0.75 pp to 2.00% and 4.00%, respectively. Five members were in favour of this rate change, and two members voted for a rate cut of 0.5 percentage points.

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

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