Minutes of the Board Meeting on 31 October 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)

The Board opened the meeting with a presentation of the large October situational report, which contained the new forecast of inflation and other macroeconomic variables.

Year-on-year consumer price growth in September 2002 was slightly lower than the July prediction. Low regulated price growth, a substantial decline in food prices and the strong exchange rate contributed the most to low inflation developments. Demand-inflation pressures also remained weak. According to the analyses, the negative output gap slightly worsened again during the last quarter.

With respect to exogenous variables, fuel prices showed some pro-inflationary tendencies. However, there was also a downward shift in the economic growth forecast abroad. Following stagnant development this year, German economic growth in 2003 should experience moderate growth of 1.5%. This corresponded to modest price developments abroad, which would be transmitted to Czech inflation as well. After a rise in 2002 Q4, the price of oil in 2003 should slightly decline over time.

The updated forecast anticipated around 2% growth in the Czech economy this year and 1.1% to 2.6% in 2003. Domestic consumption would still be a catalyst for this growth. A strong fiscal impulse existed in 2002, and according to budget figures, should reach approximately 2% of GDP. Therefore, after eliminating the effect of fiscal policy, this meant that domestic demand would increase at a slow pace only. Low foreign demand and a strong exchange rate, which reduced the profits of Czech companies and undermined investor confidence, contributed to this development. Thus, a moderate slowdown in domestic demand could be expected in 2003, at which time the additional fiscal impulse would not be as significant and private investment would be recovering at a slow pace only. This assessment, however, was associated with a high level of uncertainty, because some public budget data were not available.

The inflation forecast assumed a slight rise in inflation for the remainder of 2002. In December of this year, year-on-year consumer price growth should reach about 1%. Due to the expected drop in electricity prices, inflation should experience a drop in January 2003. During the course of 2003, prices should then rise at a faster pace, mainly due to gradual fading of the effect of low import prices and agricultural producer prices. In addition, the growth rate of regulated prices would gradually increase, though it would still remain significantly lower than was expected when the inflation target was originally set. The baseline forecast scenario did not take into account any changes in indirect taxes. In December 2003, inflation would be in a range of 1.6% to 3.0%, i.e. at the lower boundary of the targeted band.

The decline in interest rates in 2002 Q4 and subsequent rate stability was consistent with the forecast based on information available at the time of its formation.

In the discussion to follow, the Board assessed the risks involved with the forecast. One view expressed that lowering the GDP forecast would not reflect so much the newly available information as much as it would a reassessment of current domestic demand development and the contribution of fiscal policy to its growth. Most board members agreed that the new GDP forecast provided an overly pessimistic view, and the real outcome could be expected to be more in the upper half of the forecast range. However, the level of uncertainty was high concerning the extent and timing of fiscal expansion and, in turn, domestic economic activity because of the low transparency of the public finance system, which currently had a negative impact on monetary policy decision-making.

With respect to the inflation forecast, the logic of inflation targeting justified any considerations on lowering interest rates. The given level of uncertainty, however, indicated that more discretion should be taken. In addition, some board members pointed to the potential risks of reducing interest rates. These risks included the development of bubbles, for example, in the area of household lending, which had been rising for some time now at a very rapid rate. Moreover, an added complication could be the relative lack of experience with rates below the Eurozone level. This uncertainty was increasing in strength, because the risks of future exchange rate development could be perceived as more balanced for strengthening and weakening the exchange rate in comparison with the recent past. A worsened growth outlook for the Czech economy could, in addition, support depreciation expectations. Nevertheless, the actual exchange rate value could still be seen as overvalued, and any further easing of monetary conditions through the exchange rate channel would help the economy.

The timing and intensity of recovery in Western Europe was still one of the sources of uncertainty. The forecasts would remain pessimistic for the near future and optimistic over the longer run. This, though, had been going on for two years, with constant delays in the recovery process. Therefore, one opinion expressed that it was risky to rely on anticipated external recovery as a positive stimulus for the domestic economy. In opposition though, another view stated that the expected growth of 1.5% in Germany for 2003 appeared to be a good estimate that was shared by a number of analyst groups.

Following the discussion of the October situational report, the Board decided by a majority vote to lower the CNB two-week repo rate by 0.25 percentage points to 2.75%, effective 1 November 2002. Four board members were in favour of this decision, and three members voted for leaving interest rates at their existing level. The discount and Lombard rates were also lowered by 0.25 percentage points to 1.75% and 3.75%, respectively.

Author of the Minutes: Tomáš Holub, Adviser to the Governor

Comments are welcome on the following email address: Tomas.Holub@cnb.cz