Minutes of the Board Meeting on 31 July 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 July situational report, containing the new forecast for inflation and other macroeconomic variables.

Year-on-year inflation in June shifted back to slightly positive values. However, this shift was less significant in comparison to the assumption. One factor behind this development was the exchange rate of the Czech koruna vis-à-vis the dollar, which was also responsible for the continued moderate decline in import prices. A role was also played by the anti-inflationary effect of domestic demand factors, which seemed to be stronger than the assumption in the April forecast.

The forecast still expected year-on-year inflation to accelerate, i.e. relating to how the effects of exogenous factors would shift from a disinflationary to a neutral position. Compared with the last forecast, however, there was a substantial downward reassessment in the expected inflation trajectory. Within the most effective transmission period, the new forecast was headed towards the lower half of the targeted band, despite the planned indirect tax changes, the primary effects of which monetary policy should not react to.

One of the most important factors in the forecast change was the shift of the expected indirect tax corrections associated with EU entry to 2004 and a lower estimate for their primary impact. A shift in restaurant and hotel services from a reduced VAT rate to a base VAT rate was no longer expected. The accepted assumption that the slower dynamics of inflation pressures observed in past months would continue in an environment of a long-term negative output gap also contributed substantially to reducing the inflation forecast. The last factor associated with reducing the inflation forecast was the continuation of weak growth abroad and expectations of lower imported inflation associated with it.

There were less significant changes for the economic growth forecast in comparison with the inflation estimate. Alongside government consumption, household consumption stimulated by the high dynamics of real disposable incomes was still the main growth factor in 2003. The forecast assumed, however, that household consumption growth would gradually ease up. This year, GDP growth would still be restrained by the decline in investments, which was related, among other things, to delays in global economic recovery. On the contrary, net export's contribution to GDP growth would be positive, supported by the easing exchange rate component of monetary conditions. In 2004, the forecast expected another moderate boost in economic dynamics, thanks in particular to a recovery in investment growth. This would involve the effects of easing both components of monetary conditions and the start of economic recovery abroad. In all, though, the forecast implied the absence of more significant demand pressures on inflation up to the end of 2004.

A decline in interest rates during the second half of 2003 and the stability of these rates throughout the following year was consistent overall with this forecast and its assumptions.

Following the presentation of the situational report, the Board discussed the new forecast and the uncertainties associated with it. There was consensus among board members that the downward reassessment of the inflation forecast was more substantial than the figures alone for the last quarter actually suggested, due to the reassessed view for some features of the macroeconomic transmission mechanism. There were concerns in this respect whether or not the corrections in the forecast had been overshot. On the contrary, however, it was stated that this move involved a reasonable reassessment of the forecast, taking into account, among other things, the observed deviations in inflation since the previous assumptions.

Besides the uncertainties concerning the effect of the output gap on inflation, questions also remained about the effect of current monetary conditions on the economy. Inflation expectations, and in this respect even real interest rates, were not easy to assess. The baseline scenario for inflation worked with backward-looking expectations, which would mean relatively tight real rates in view of the actual low inflation. However, it was suggested by some board members that no support for this theory could be found in the available data. According to sample surveys, inflation expectations were at a higher level than the forecast assumed. Household lending and consumption continued to increase rapidly, and there were no signals, even from the corporate sector, that real interest rate settings were perceived as restrictive. From this standpoint, actual interest rate conditions could already be sufficiently eased.

There was also uncertainty over how the strong appreciation of the koruna last year influenced the economy and how favourable the effects of the current easing of exchange rate conditions would be. One view expressed that the stimulating impact of the exchange rate would be relatively strong. On the other hand, it was stated that the exchange rate in and of itself could not significantly accelerate economic growth without a recovery in foreign demand, which had experienced continual delays.

As in previous months, uncertainty continued over the timing of indirect tax changes and implementation of public finance reforms. A view expressed that this uncertainty should be accounted for during decision-making on interest rate settings. Nevertheless, some board members assumed that even exploring the possible alternatives for fiscal development would not change the overall picture, i.e. the absence of demand pressures on inflation during the period of monetary transmission.

Some of the members stressed that the inflation forecast was headed towards the lower half of the target, and after the temporary effect of tax corrections died out, it would return to the lower boundary. Without starting up economic recovery, there was a real threat that inflation would again fall below the targeted band in 2005, while on the other hand, the risk of overshooting the target was very low. In contrast, it was said that demand pressures would undoubtedly increase, however, it was not known how fast and how intense this increase would be. The aim of monetary policy should not be to fully offset the impact of current exogenous shocks, because it could produce unwanted secondary effects. It was mentioned that the demotivating effect of the currently low interest rates on the creation of savings and deposits should also be taken into account.

At the close of the meeting, the Board decided to lower the CNB two-week repo rate by 0.25 percentage points to 2.00%, effective 1 August 2003. The Board also decreased the discount rate and Lombard rate by the same amount to 1.00% and 3.00%, respectively. Five members voted in favour of this decision, and two members voted for leaving rates unchanged.

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

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