Minutes of the Bank Board Meeting on 30 January 2003

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 January situational report containing the new forecast on inflation and other macroeconomic variables.

During the last quarter of 2002, year-on-year CPI inflation was slightly lower than the October prediction. Low inflation was achieved through a combination of exogenous and endogenous factors. Import prices, agricultural producer prices and the absence of demand pressures, brought on by a worsening output gap, had a substantial impact. According to the forecast's baseline scenario, the inflation outlook did not change significantly against the October prediction. After the disinflationary effect of exogenous factors die out and in the context of the gradually closing output gap, inflation should fluctuate near the lower boundary of the inflation target during the first half of 2004.

The January forecast, which took into account the newly available information and the revised GDP data, brought about a reassessment of the economic growth perspective. The bottom of the economic cycle was reached in 2002.Growth would start to accelerate slightly in 2003 and 2004. In contrast to October, the economic growth forecast was adjusted upward for 2003 and downward for 2004. The role of investment and net export was reassessed. These factors would contribute to faster economic growth in the new forecast as opposed to the October forecast, in which the dominant source of growth was household and government consumption. In 2003, the effects of domestic growth factors - particularly looser monetary conditions - would be further constrained by less-than-favourable global developments. In spite of moderate economic growth acceleration, demand inflation pressures in the economy would not strengthen owing to the negative output gap closing at a gradual pace only.

The forecast's baseline scenario was associated with a number of uncertainties. The effects of public finance reform would enter into the timeframe of monetary transmission. It was now very difficult for the central bank to estimate where the future fiscal reforms would be headed, including the impact of these reforms. This uncertainty would likely lead to considerations on leaving rates higher than the level corresponding to the forecast's baseline scenario. The possible combination of looser monetary conditions and a higher fiscal impulse was one of the pro-inflationary risks of the baseline scenario. Therefore, one of the alternative scenarios of the model simulation dealt with an estimate of the effects of looser monetary conditions on economic development. Uncertainty was also associated with international developments. The risk of escalation of the international situation, along with any related swings in oil prices and global financial markets, was also accounted for in the model simulation according to one of the alternative scenarios.

The January forecast, which reflected the available information at the time of its creation, was consistent with the slight decline in interest rates at the beginning of 2003 and the subsequent stabilisation of these rates.

In the discussion to follow, the Board focused its attention on the revision of GDP data and its effects on the forecast. The Board agreed that January's backward revision of data affected the interpretation of economic development. It was expressed that the new GDP data modified the interpretation for past economic development, because there was a change in the structure of growth sources. This change in interpretation of past developments could have implications for the forecast of economic development. The relative increase in the role of investment and net export as sources of economic growth in the past could, for example, have an impact on the output gap for the period of monetary transmission. It was also mentioned that, rather than changing the interpretation, the revision of data eliminated some of the inconsistencies. Low GDP growth in the past was not consistent with certain indicators, such as higher tax collection or a higher volume of sales. The revision of data indicated that the economy was resistant to external shocks such as slowed global growth and the accelerated appreciation of the koruna. The Board considered this resistance to be a positive development.

After considering the impact of data revision on formation of the economic development forecast, the Board then discussed how a lack of knowledge of the correct GDP data had an effect on monetary decision-making. It was said that, regardless of the revision of data, the monetary policy instruments were still adequately set in relation to the continuing disinflationary process. The assumption of a negative output gap was not doubted, and the reduction in rates allowed the tightening of the foreign exchange component of monetary conditions to be compensated. It was expressed that monetary policy rates would have been lower if the correct data had been known, because one of the codetermining factors of the process of reducing rates was a constraint in the form of a growing external imbalance. With knowledge that the economy was not in danger of crossing the safety limit for the current account deficit, due to higher household consumption, the monetary policy response could have concentrated on inflation returning to the targeted band at a quicker pace. However, another view expressed that the revised data, placing the Czech economy in more favourable light, could be interpreted as a reason for not cutting monetary rates in view of the already low level for real rates.

The Board then focused on the risks related to the forecast's baseline scenario. Members agreed that there was no evidence in the economy of excessive demand inflation pressures now or even during the period of monetary transmission. Following the logic of inflation targeting, a rate reduction would be an adequate reaction to the presented forecast. For the following four quarters, the inflation forecast was below the inflation target and was consistent with a moderate decline in rates at the beginning of 2003. It was said that the central bank's strategy should allow the inflation target to be reached with the lowest possible rates.

There was also consensus among board members that the uncertainty behind the approach of fiscal reform relating to its scope, speed and choice of instruments on the income and expense side of the budget significantly complicated decision-making on the adequate setting of monetary rates. If the reform were carried out at a slower pace than the forecast's baseline scenario suggested, in line with government objectives, then there could be looser monetary conditions along with a higher fiscal impulse. The high uncertainty associated with the fiscal outlook and also with other risks for the forecast's baseline scenario - primarily related to geopolitical factors - was repeatedly indicated as a reason for leaving rates unchanged.

Board members also discussed the risk in the upcoming period of wages being set incorrectly to the internal conditions of the Czech economy, particularly low inflation and higher unemployment, as well as to external conditions that were still characterised by weak foreign demand and more stringent competition on export markets. Generation of inappropriate wage expectations from the public sector was indicated as a significant pro-inflationary risk.

Another argument for leaving rates unchanged was put forward. One of the main reasons inflation had been moving back to the targeted band at a slower pace was that the speed of price deregulation was much lower than was anticipated by the scenario used to set the inflation target. Attention was also drawn to the risk of additional rate cuts for generating savings and indebted households. The possibility of leaving rates unchanged was warranted in the discussion by already looser monetary conditions through the exchange rate and also by the fact that some board members placed the majority of the forecast risks on the inflation side.

Following the discussion of the January situational report, the CNB decided by a majority vote to reduce the CNB two-week repo rate by 0.25 percentage points to 2.5%, effective 31 January 2003. Four members voted in favour of this decision, and three members voted for leaving interest rates unchanged. The discount and Lombard rates were reduced by the same 0.25 pp to 1.5% and 3.5%, respectively.

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

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