Minutes of the Board Meeting on 24 April 2003

Present at the meeting: Zdeněk Tůma (Governor), Oldřich Dědek (Vice-Governor), Michaela Erbenová (Chief Executive Director), Jan Frait (Chief Executive Director), Pavel Štěpánek (Chief Executive Director)

The Board opened the meeting with a presentation of the April situational report containing the new forecast for inflation and other macroeconomic variables.

Inflation still remained very low due to a combination of external factors, such as a sharp decline in agricultural producer prices, the strong year-on-year appreciation of the Czech koruna vis-à-vis the dollar, a continuation of low imported inflation, and slow economic growth abroad. Internal demand pressures also did not affect price growth.

The forecast still expected inflation to pick up speed in the upcoming period due to the exogenous effects gradually dying out. In contrast to the January situational report, the anticipated harmonisation of indirect tax changes was also accounted for in the forecast. This measure was related to signing of the EU accession agreement, which incorporated tax harmonisation. The direct impact of indirect tax corrections on the price level was estimated to be around 2.5 percentage points over the next two years. As a result, the inflation forecast would be situated slightly above the CNB's targeted band for a temporary period of time. Tax changes would probably have an indirect effect as well via inflation expectations, wage negotiations, etc. According to the forecast, however, these effects would be significantly reduced in view of the current economic situation and the exceptional character of tax changes.

In comparison with the second half of 2002, the rate of economic growth this year should slightly increase. Relatively loose monetary conditions coupled with the associated gradual recovery for investment and net export would have a favourable effect. On the other hand, growth would be dampened by the continuing weak business cycle abroad. This should improve during 2004. A slowdown in household consumption would, nevertheless, occur due to the negative income effect of rising indirect taxes. Hence, GDP growth in both years would evidently remain below 3%, and the unemployment rate would settle at around 10%. The absence of demand pressures on inflation would continue as a result. Starting in 2004, this situation would gradually start to change.

Data on public budget deficits for 2002 were being reassessed downward. Implementation of reform measures had been postponed for now. Therefore, the new forecast anticipated a less ambitious form of fiscal consolidation. According to a sample survey carried out on households, inflation expectations had increased recently, which could reflect the expected price effects of EU accession. However, the forecast did not anticipate any substantial effect on wage negotiations and inflation pressures from these expectations.

The more or less stable interest rates in upcoming months followed by a gradual rise in these rates were consistent with the forecast. This conclusion was conditioned by information available at the time the forecast was formulated and by the assumption that monetary policy would not react to the primary effects of tax changes.

Following the presentation of the situational report, the Board turned to a discussion of the new forecast and the associated uncertainties and implications for setting interest rates. There was consensus among members that the predicted rise in inflation temporarily above the targeted band - caused by anticipated indirect tax changes - could not automatically be considered a reason for increasing interest rates. This particular situation fell under an escape clause. In addition, it was expressed that if tax changes were not included in the scenario, the current inflation forecast could fall below the January forecast due, among other things, to the constant delays in economic recovery abroad, a decline in the risks associated with the price of oil, and flat growth next year. If the rise in taxes were postponed until later, and at the same time, some of the forecast's disinflationary risks materialised, then it would be appropriate not to exclude the possibility of an additional, moderate cut in interest rates.

The Board devoted a considerable amount of time discussing the indirect effects of tax corrections. Most members agreed that these effects would probably be limited in nature. In this respect, it was mentioned that the current low price growth provided a very opportune situation for implementing tax changes. Postponing these changes until they accumulated at some point and time would not be desirable and would increase the risks of secondary inflationary pressures and, in turn, the need to employ monetary policy in the future.

Board members agreed that fiscal development was a significant source of uncertainty. The timing and form of public budget consolidation were not known at present. If reform relied more on increasing taxes than on changing the structure of expenditures, this would be a less favourable option for economic development and interest rate settings. In view of GDP growth, there was also uncertainty about the intensity of investment and net export recovery connected with a certain spontaneous easing of monetary conditions. This easing was caused by nominal exchange rate stability and a decline in real interest rates in the future due to rising inflation expectations. The rate of recovery abroad also remained uncertain. However, in comparison to previous months, the uncertainty associated with the geopolitical situation had been reduced.

At the close of the meeting, the Board decided unanimously to leave the CNB two-week repo unchanged at 2.50%.

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

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