Minutes of the Board Meeting on 29 August 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 Štěpánek (Chief Executive Director), Bohuslav Sobotka (Minister of Finance)

The Bank Board discussed the August situational report on economic and monetary development. This report contained an analysis of information newly available since the previous report had been discussed, together with an assessment of the significance of that information with respect to the July inflation forecast. The fall in consumer price inflation in July was in line with the forecast, despite being rather smaller than the central bank had predicted. The greater-than-expected increase in consumer prices was due chiefly to recreation prices and, to a lesser extent, to prices of regulated commodities. Conversely, annual industrial producer price inflation, at -1.1% in July, was 0.5 percentage points lower than had been forecast by the CNB.

Numerous short-run indicators from the real economy were pointing to a slowdown in economic growth. The year-on-year growth rate of industrial production slackened to 1.3% in June. Retail sales were 0.5% lower than a year earlier at constant prices. Developments on the labour market - most notably a continuation at around trend of the rise in the seasonally adjusted unemployment rate and a further decrease in the number of job vacancies - were also consistent with an assumption of slowing economic activity.

There were mixed developments as regards future inflation pressures from the external environment. The expected growth in oil prices on world markets suggested a moderately pro-inflationary impulse with respect to import prices, whereas the current GDP growth rate in Germany and a fall in the GDP growth forecast there indicated a softening of external demand growth relative to the assumptions contained in the July forecast. Likewise, annual industrial producer price inflation in the EU, which had been -1% in July, was also anti-inflationary.

The effect of the recent floods on the Czech economy was assessed on numerous levels. According to the preliminary and incomplete information available, the supply side of the economy had been affected only slightly. Damage to production facilities was concentrated in just a few sectors, most notably the chemical, food and power generation industries. During the discussion of the demand situation for this year, the view was expressed that the floods were unlikely to cause a significant decline in economic growth compared with the July forecast. On the contrary, a modest positive demand impulse could be expected next year, due mainly to an expected rise in investment activity both in the private and public sectors. The estimated current level of the negative output gap should accommodate both the possible modest decline in potential output this year and the expected demand stimulus in 2003.

Following the presentation of the situational report, the Board heard detailed information from the Minister of Finance on the flood-related budget changes under consideration. This led to an in-depth discussion of the preliminary evaluation of the planned tax changes' macroeconomic implications for prices and household consumption and the elimination of the effect of foreign aid inflow on the koruna's exchange rate. There was general agreement that in the context of the expected economic trends it would be highly desirable to spread out, as much as possible, the tax changes' restrictive impact over time and thereby to attempt to minimise the downward effect on domestic demand. Although the Board members attached differing significance to the effect of the planned tax changes on economic growth, they concurred that the central bank would regularly monitor and assess fiscal policy in this area. There would need to be an assessment of the risks - short-term and long-term - associated with an absence of major fiscal reforms. As to the potential implications of the foreign aid inflow for the koruna's exchange rate, it was stated that the existing agreement between the Ministry of Finance and the CNB was sufficient to prevent the inflow of flood aid from abroad giving rise to appreciation of the koruna's exchange rate.

The next item on the agenda - loosely related to the foregoing exchange of information between the Board and the Minister of Finance - was the expected pace of economic growth this year and next year. The Board agreed that the current increasingly robust signs of a slowdown in domestic economic activity were in line with the CNB's previous expectations. It was highly likely that this was confirmation of the lagged adverse consequences of the recent excessive real appreciation of the koruna and depressed external demand on domestic economic growth.

The issue of the exchange rate was discussed on two levels: with regard to the current exchange rate situation on the foreign exchange market, and with regard to central bank strategy in this area. The opinion was expressed that a turnaround was occurring as regards the market view on the future exchange rate and that expectations were now more balanced. The Board agreed that the exchange rate could only be appraised from the long-run perspective. Consequently, the recent depreciation could only be interpreted as a modest correction of the previous excessive appreciation. This modest correction changed nothing in the CNB's view regarding the exchange rate. The CNB was aware of the now perceptible negative consequences of the strong koruna on the domestic economy and remained ready to use all its instruments, including foreign exchange intervention. This readiness to respond flexibly to the koruna's adverse exchange rate trend was confirmed unequivocally by the Board during the discussion of central bank's strategy on the foreign exchange market.

The recent floods constituted a new risk to inflation and to the economy as a whole. In this context it was mentioned that there might be disturbances to the stability of some of the behavioural linkages on which the forecast of key macroeconomic variables were based, and that the Czech Statistical Office might also face temporary, objective problems when collecting and disseminating data. This increased the risk of errors in the estimation of future trends relative to the past period. Although the floods were not expected to affect prices significantly, they could generate price increases in particular segments of the economy, most notably agricultural producer prices, construction work prices and insurance premiums. The quantification and timing of these price effects constituted an important uncertainty surrounding the inflation forecast.

In a concluding discussion on interest rates, views were expressed that if, in the months ahead, the recent signals of a more pronounced slowdown in economic activity were to be further confirmed, and if, simultaneously, there were no easing of monetary conditions by means of the exchange rate channel, it might be appropriate to consider lowering interest rates further.

After discussing the August situational report, the Board decided unanimously to leave the two-week repo rate unchanged at 3%. It also decided to continue with operations on the foreign exchange market according to the existing market conditions.

Author of the Minutes: Tibor Hlédik, Adviser to the Board

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