Minutes of the Board Meeting on 29 July 2004

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.

The inflation forecast over the short term was adjusted slightly downwards against April. During the period of the most effective transmission, the inflation forecast was aimed towards the midpoint of the inflation target, similar as in April. Lower inflation dynamics were triggered by a slowdown in food price growth, reduced leakage of cost inflation pressures over to consumer prices, and by lower demand pressures, which were conveyed in the forecast through a rise in the initial negative value of the output gap. The forecast of inflation, adjusted for the primary impact of tax corrections, was aimed slightly below the target's midpoint during the period of the most effective monetary transmission.

The economic growth forecast over the short run was adjusted slightly downwards against April. In the period of the most effective transmission, the forecast was adjusted slightly upwards. The economy had reached a turning point, and during the forecast's range, it would end up in an economic recovery phase. Investments began to spark recovery. Economic growth was stimulated by eased monetary policy conditions, the impact of which accumulated over time. The forecast worked with the assumption of gradual recovery for the European economy, which would bring with it increased demand for Czech exports. The forecast was built on the assumption that the effect of fiscal policy would be neutral.

The interest rate trajectory, consistent with the July forecast and its assumptions, was growing. It was, nevertheless, positioned slightly lower than in the April forecast.

Following the presentation of the situational report, the Board turned to a discussion of the new forecast and the uncertainties associated with it. The Board agreed that the interpretation of the current economic situation in the July forecast was similar to that in the April forecast, however, the July forecast more accurately expressed expected economic development. The Board's assessment that anti-inflationary risks in the April forecast were substantial proved to be an accurate reading of the situation.

The Board discussed the economic interpretation of the new forecast. As was repeatedly stated, the available information confirmed that a turning point had, in fact, been reached. During the period of the most effective monetary transmission, there would be economic growth recovery, and inflation would slightly accelerate. Economic growth was now pulled by investments. In a phase of economic growth recovery, cost pressures could leak over to inflation at a faster pace than at the present time. The financial indicators showed the possibility of moderate inflation pressures. June' s hike in rates was consistent with this interpretation. In addition, one view expressed that the current development corresponded more to a phase of stable, low-inflation growth where inflationary pressures would not reoccur. The inflation impulses were temporary in nature, caused primarily by tax administration measures and exogenous shocks. In this respect, it was also said that the Czech economy was growing at a slower rate than the other countries in the Central European region and that the monetary stimulus should be reduced in an adequate manner.

The Board also focused on the issue of cyclical and structural inflation factors. In a model forecast, monetary policy reacted predominantly to cyclical inflation factors. It was said that inflation would be formed by cyclical factors in an economic recovery phase, and monetary policy should react to these factors sufficiently in advance. It was also said that the Czech economy was still going through a stage of substantial structural changes and that the impact of these changes was not sufficiently accounted for in the model. They should, therefore, be treated in the same way as forecast risks. A potential bias in measuring inflation that could occur as a result of underestimating the qualitative changes of consumer goods was given as an example. It was mentioned that this bias could be greater for the Czech economy than for developed economies and that the neutral monetary policy rates could be lower in such a situation.

The Board addressed the issue of equilibrium interest rates. The methodology used to estimate neutral rates should not only include an estimate of GDP growth potential and a definition of price stability. It should also include factors accounting for the Czech economy's convergence process, which were reflected in the definition of the inflation target as well. In addition, it was expressed that the Czech economy was very open, and therefore, it was not possible to discuss equilibrium rates separately from the discussion concerning the exchange rate component of real monetary conditions. It was mentioned that the existing level of interest rates in the Czech economy reflected, among other things, the fact that the domestic currency had gone through an overvaluation phase in the past and that it had been advantageous in that phase to compensate for the effects of a strong currency by easing the interest rate component of monetary conditions.

At the close of the meeting, the Board decided to leave the CNB two-week repo rate unchanged at 2.25%. Four board members voted in favour of this decision, and three members voted for increasing the rates by 0.25 of a percentage point.

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

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