Minutes of the Board Meeting on 29 April 2004

Present at the meeting: Zdeněk Tůma (Governor), Oldřich Dědek (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 4th situational report on economic and monetary development, and along with it, the new macroeconomic forecast.

The report emphasised the relaxed nature of monetary conditions, and in particular, the exchange rate component. In relation to relaxed monetary conditions in the past, the worsening tendency of the negative output gap had ended. Developments in Q1 showed that the low-inflation environment, which was characteristic of economies performing below their growth potential, still existed.

In view of more relaxed monetary conditions than in the previous macroeconomic forecast, faster economic growth was expected. The newly available data for 2003 indicated that fiscal policy's growth input was lower than originally expected. The contribution of foreign trade should increase growth, as was also indicated by certain preliminary data for Q1. The share of investments was expected to increase as well, backed by the improved financial situation of companies.

Inflation pressures associated with the closing output gap and its gradual shift to positive values would start to have a larger impact as early as the end of this year. It was assumed that the corresponding reaction of food prices to the rise in agricultural producer prices had not yet taken full effect. In addition, rising oil prices were still expected to affect the related price groups. The higher estimate for the secondary effects of indirect tax changes was also a change from the last forecast.

These factors would cause a shift in the inflation forecast to a level of about 4% year-on-year CPI growth by the end of this year. In the second half of 2005, inflation should fluctuate in the centre of the targeted band, i.e. around 3% of the year-on-year CPI. The gradual rise in interest rates was consistent with the new macroeconomic forecast.

In addition to the baseline scenario, two alternative scenarios were also included in the situational report. These scenarios described macroeconomic and price development in the event of more serious deviations from the base forecast. The first alternative discussed the various levels of impact, i.e. higher or lower, that inflation expectations would have in relation to indirect tax adjustments, which affected the level of interest rates consistent with the forecast by about + 0.5 percentage points. The second alternative scenario was based on the assumption of a stronger koruna exchange rate vis-à-vis the euro, and this scenario would end near the CNB's January forecast.

Following the presentation of the situational report, board members turned to a discussion on the positioning of the new forecast, which substantially shifted expected economic growth and inflation upwards in 2004. The Board considered the new data on the structure of 2003 GDP growth to be important. The realisation that the weight of non-fiscal factors was higher than previously expected was accepted as one of the basic arguments in favour of dynamic GDP growth in the future.

It was said that global economic recovery generated by developments in the USA and China had no discernable effect so far on demand growth and inflation pressures in the European Economic Area. Uncertainty related to the speed and vigour of recovery for the Czech Republic's main business partners was indicated as the main forecast risk. In this respect, the absence of relevant Q1 data was mentioned as a reminder. One view expressed that forward-looking monetary policy was based on the analysis of long-term trends, and an ex post reaction to any additional information would create the risk of delayed decision-making.

Although an amendment to the VAT Act was passed, continued uncertainty was not only the immediate secondary effect, but above all, it involved longer-term consequences which were influenced by inflation expectations, and monetary policy must respond to them.

There was consensus among board members that a moderately prevailing risk for the new forecast was the likelihood of lower inflation as well as lower economic growth. The Board confirmed that the gradual rise in interest rates was consistent with the forecast's baseline scenario. In the light of this situation, the Board pointed to the unsustainability of negative real interest rates in the long run, especially in a phase of economic recovery.

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: Petr Krejčí, Adviser

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