Minutes of the Board Meeting on 29 January 2004

Present at the meeting: Zdeněk Tůma (Governor), Oldřich Dědek (Vice-Governor), Luděk Niedermayer (Vice-Governor), Jan Frait (Chief Executive Director), Pavel Racocha (Chief Executive Director)

The Board opened the meeting with a presentation of the January situational report, containing the new forecast for inflation and other key macroeconomic variables in 2004 and 2005.

Consumer prices in December 2003 increased 1 % year-on-year. This rise in inflation was higher than predicted by the CNB's October forecast. Excessive price growth in relation to the forecast was seen especially in food and regulated prices. On the other hand, adjusted inflation registered lower-than-expected growth. Despite certain growth acceleration, though, food price development during the last quarter of 2003 did not generate any substantial deviation from the medium-term link between food prices and the cyclical position of the economy on the one hand and cost factors on the other. Since formation of the October macroeconomic forecast, there had also been higher-than-expected household consumption growth. This higher growth was triggered by the interest rate settings for monetary conditions in the past, rapid growth of real disposable incomes in 2003 and the effect of non-systematic factors in the form of anticipated tax legislation changes.

In the horizon of the most effective transmission, inflation was within the targeted band, similar to the situation with the October macroeconomic forecast. With the exception of import prices, all factors in 2004 would contribute to inflation growth. In comparison with the previous forecast, the import price forecast was lowered, despite the fact that German inflation was higher than predicted in the 10th situational report and that the nominal exchange rate depreciated. The main reasons behind this decline in import prices were exchange rate appreciation vis-à-vis the dollar and a deviation in actual development from the forecast at the end of 2003. The expected development for the output gap was a systematic factor contributing in particular to higher inflation. Looser real monetary conditions and faster foreign recovery were the main reasons why current output converged to the potential of the economy at a faster rate. The dynamics of household consumption within the cycle corresponded to the components of real incomes. Employment followed the economic cycle with a certain time lag, while real wages were in line with the past anti-cyclical development. In the previous period, nominal wage rigidity contributed significantly to this development. The impact of rising unemployment would not be reflected in wage restraint until some time in 2004.

Regulated prices would have a large impact on how fast inflation returned back to the target and on the observed deviation compared with the previous forecast. However by mid-2005, the share of regulated prices in total inflation would decline to 0.5 percentage points. In addition, food prices would contribute to the observed difference in the inflation forecast for 2004 despite primary factors, such as import prices and agricultural producer prices, behaving in a similar manner or with less intensity. On the contrary, adjusted inflation in 2004, excluding fuel, was situated below the previous prediction. This was related to the development of import prices. However, the output gap would not close up at a faster pace until 2005.

The current level of nominal interest rates in Q1 as well as a gradual rise in these rates during the following period was consistent with the forecast.

Two alternative scenarios were worked up for the forecast. The first scenario quantified the effect of the shift in catering and accommodation services from the lowered VAT category to the base VAT category by the Czech Republic's EU entry date. In contrast to the baseline scenario, this scenario was characterised by a higher level of total inflation starting in Q2 2004 and a slight slowdown in economic activity at the end of 2004/beginning of 2005. Considering that monetary policy reacts only to the secondary effects of tax corrections, this alternative in comparison with the baseline scenario would not put more pressure on tightening monetary policy until the middle of this year. The second scenario would map out the risks associated with the observed appreciation of the euro vis-à-vis the US dollar. This scenario, depending on the assumed reaction of the ECB to euro appreciation, would help ease inflation pressures and lead to lower nominal interest rates in the Czech Republic.

Following the presentation of the January situational report, the Board discussed the new forecast and the risks associated therein. There was agreement that, in principle, current and expected macroeconomic development in the Czech Republic were reflected well in the inflation forecast. For this reason, the discussion was primarily focused on the risks associated with the forecast.

When assessing the overall balance of inflation risks, most of the board members observed risks skewed in a pro-inflationary direction. Other members considered the forecast risks to be more or less balanced. One of the main risks was identified as the estimate of the impact tax changes had on inflation expectations, wage development and overall demand, which was also influenced by the income effect. The extent of compensation that could accompany these tax-harmonising changes would also be significant. Expected economic growth and a closing output gap could, in this respect, have more of an inflationary effect than in the past. However, it was said that future CPI inflation adjusted for the direct effect of tax changes still indicated the continuation of a low-inflation environment.

The Board considered the current interest rate settings to be eased, especially in relation to expected price development. In this respect, it was pointed out that interest rates were lowered to 2 % at a time when there was a threat of deflation and significantly reduced demand in the global economy. Since this time, the basic risks of external development had substantially declined. Czech economic performance was satisfactory. Corporate sector polls showed improvements in using capacity, and the majority of indicators at the macro- and micro-level confirmed the positive tendency in the real economy. The European economy was slowly recovering from a slump, but had maintained around two per cent inflation. The United States, on the other hand, registered dynamic economic growth with low inflation. This occurred in an environment of very low interest rates and sharp depreciation of the dollar against the euro.

The only anti-inflationary risk that board members discussed in any detail was the scenario quantifying the more substantial weakening of the USD and its impact on a slowdown in European economic growth. There was consensus that this alternative forecast scenario from a qualitative standpoint correctly captured the impact of the depreciated dollar on the Czech economy. However, from a quantitative standpoint, the board members attached different weights to this particular risk.

At the close of the meeting and following the discussion on the situational report, the Board decided unanimously to leave the CNB two-week repo rate unchanged at 2 %.

Author of the Minutes: Tibor Hlédik, Adviser

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