Minutes of the Board Meeting on 27 January 2005

Present at the meeting: Z. Tůma (Governor), O. Dědek (Vice-Governor), L. Niedermayer (Vice-Governor), M. Erbenová (Chief Executive Director), P. Racocha (Chief Executive Director), P. Štěpánek (Chief Executive Director)

The Board opened the meeting with a presentation of the 1st Situational Report for January 2005, which contained the new macroeconomic forecast.

The main changes in comparison to the October forecast consisted in a downward reassessment of future demand pressures and lower inflation expectations during the whole forecast period. More substantial demand pressures according to the forecast were postponed until 2006. Expectations of more moderate GDP growth and a somewhat wider output gap were associated with this. In view of this development, there was a downward shift in the implied interest rate trajectory in comparison to the previous forecast. During the period of monetary transmission, inflation would be slightly below the midpoint of the inflation target band. The slight reduction in interest rates in Q1 2005 was consistent with the January forecast, and their gradual increase was postponed until the first half of 2006.

Behind these changes were domestic as well as foreign effects. Not only was the influence of the koruna's nominal and real appreciation from the end of 2004 on the domestic economic growth and inflation taken into consideration, but also anticipated weaker foreign growth and more moderate import price development.

Certain downward reassessment of the assumptions relating to the dynamics of domestic economic growth had occurred. This reassessment was caused by the revision of GDP time series for 2003 and the more restrictive impact of fiscal policy in 2004 contrary to expectations. In addition to this, the CNB forecast expected somewhat lower real export and investment dynamics compared to 2004. The economy was still in a stage of relatively fast growth, however, due to the above mentioned reasons, the growth outlook was slightly reduced.

The January forecast expected CPI inflation growth ranging from 1.6% to 3.0% in December 2005 and in June 2006 between 2.0% and 3.4%. The GDP forecast for 2004 was adjusted to 3.5% to 3.7%. The current 2005 forecast was expecting GDP growth ranging between 3.2% and 4.4% and for 2006 from 3.0% to 5.0%.

After the presentation of the 1st Situational Report, the Board discussed the risks of the January forecast. Board members agreed that the upcoming period would be one of lower demand pressures, inflation and economic growth. There was also agreement regarding the influence of declining foreign prosperity on the Czech economy, though full agreement on the intensity of all these processes and consequently on the appropriate monetary policy reaction had not been reached.

Board members agreed that, from the monetary policy point of view, the predictability of public finance development was declining. Unexpectedly good results for the 2004 state budget led to the restrictive influence of fiscal policy on economic growth, which was not possible to fully predict in the CNB forecast. For 2005, this uncertainty would grow even more due to a wide range of hard-to-predict factors. One of the greatest risks was the uncertainty of how the Government would deal with the state budget savings transferred to reserve funds. The Board agreed that these reserves should not be disbursed to supplementary budget expenditures in 2005, because this could cause excessive fiscal expansion.

The Board also generally agreed that exchange rate development at the end of 2004 and during January 2005 was not a major deviation from the trajectory of the equilibrium exchange rate, but signalled a risk of a more substantial inflation decline, and thereby was a danger to reaching the inflation target within the forecast horizon. The severity of this risk was perceived by the board members in different ways.

During the monetary meeting, an opinion prevailed that the January forecast brought forth a number of arguments leading towards a possible cut in interest rates. The following four factors were indicated as being the strongest: the GDP time series revision for 2003, the more restrictive impact of fiscal policy in 2004, considerable exchange rate strengthening, and lower foreign demand.

There was also an opinion that the observed intensity of the disinflationary effects in the context of the overall favourable growth performance of the economy only justified postponement of an interest rate increase. This opinion was also underlined by an argument that lowering rates would be difficult to communicate and could worsen the predictability of monetary policy.

However, an argument dominated the discussion that monetary policy should react precisely when it recognised the need to lower rates, and not with a delay, when it could then take on a passive role. This applies in spite of the fact that a rate cut was accompanied under the current assumptions by an understanding that they would be increased at a later time.

When considering the risks, the possible impact of lowering interest rates on financial stability was also taken into account, especially in relation to the yet unsaturated household loan and mortgage market. There was consensus in this respect that lowering the interest rates would not lead to fluctuating financial stability.

At the close of the meeting, the Board decided to lower the CNB two-week repo rate by 0.25 percentage points to 2.25%. The repo rate cut was also reflected in a reduction in the Lombard rate to 3.25% and the discount rate to 1.25%. Four members were in favour of this rate change, effective 28 January 2005, and two members voted for leaving rates unchanged.

Author of the Minutes: Vladislav Flek, Adviser to the Board

Comments are welcome on the following email address: Vladislav.Flek@cnb.cz