Minutes of the Board Meeting on 24 February 2005

Present at the meeting:

Z. Tůma (Governor), L. Niedermayer (Vice-Governor), M. Singer (Vice-Governor), M. Erbenová (Chief Executive Director), J. Frait (Chief Executive Director), R. Holman (Chief Executive Director), P. Řežábek (Chief Executive Director)

The Board opened the meeting with a presentation of the February situational report. The presentation concentrated on evaluation of the risks of the January macroeconomic forecast. The risks changed over time according to the gradual assessment of the new information, which was not available at the time the forecast was formulated. Assessment of the new information showed that, in relation to the January forecast, the risks shifted in an anti-inflationary direction.

There were a number of factors behind this anti-inflationary shift. January inflation reached 1.7%, which was a lower figure than used in the January forecast. The development of adjusted inflation, excluding fuel, could be assessed similarly. Furthermore, the exchange rate component of monetary conditions was tightened. Cost factors were not sending inflation signals to the economy. The latest figures on import and producer prices were slightly lower compared to the January forecast. Newly available information on business cycle indicators, such as industrial production, construction and retail sales, were in line with Q4 2004 GDP growth at around 3.5%.

Following the presentation of the situational report, the Board discussed the risks associated with fulfilling of the January forecast as well as related macroeconomic issues. It was said repeatedly that the newly available data confirmed the positioning of the January forecast and that the January interest rate cut was an adequate monetary policy reaction, even though it was somewhat unexpected at the time of the decision. The Board agreed that the Czech economy was henceforth low-inflationary in nature and that, in the monetary policy horizon, there were no apparent demand inflation pressures. According to the available information, the existence of a more significant inflation impulse could not be assumed even for factors that, according to the assumptions of previous forecasts, were sending inflation impulses, for example food prices.

The Board further discussed the distribution of risks in relation to the January forecast. It was repeatedly said that risks were accumulating on the anti-inflationary side. In this respect, there were opinions that it was not yet clear whether this was the beginning of a new trend or whether this was due to the influence of cost and exogenous factors, which could only be temporary in nature. It was also said that it was difficult to predict in the current situation fiscal policy' s contribution to aggregate demand during the next few years. On the other hand, it was repeatedly mentioned that risks were significantly accumulating on the anti-inflationary side of the forecast, and that there was no need to hold off a rate change in order to confirm this development.

In this respect, the board members concentrated on the issue of interest rate stability. The following two views were presented during the discussion. It was said that interest rate stability was beneficial to the economy and that interest rates should be changed only if there was enough convincing evidence in favour. It was, however, mentioned that monetary policy should react with an interest rate change every time relevant information was available to indicate a significant change in inflation pressures. Should there be a correction in the ongoing trend at a later stage, it would be possible to change rates in the opposite direction. In this respect, there was an opinion that real interest rates, and not nominal interest rates, should be assessed, and therefore, decreasing nominal rates in the current situation of declining inflation, as well as the accumulation of risks on the anti-inflationary side, was an adequate monetary policy reaction.

The Board then discussed the settings of monetary conditions. It was said that the strengthening Czech koruna tightened exogenously monetary conditions. In this respect, it was stated that the Czech economy had to adjust to this kind of monetary tightening in 2002, and it was possible to assume that, in the current situation of robust growth, the adaptability of the Czech economy would be better than back in 2002. It was also pointed out that a significant decline in the yield curve was noted over the past month, which had eased monetary conditions. It was also said that a more significant interest rate cut could, in the current situation of economic growth, increase the risks of financial instability in the future, and even these remote risks needed to be accounted for when making decisions. On the contrary, it was mentioned that monetary tightening could occur even as a result of declining inflation expectations and that an interest rate cut could mean only sustaining monetary conditions, and not easing them.

The Board also discussed the supply and demand shocks in the economy. It was stated that the current inflation development was caused to certain extent by the supply shocks in the economy and also international development, which was pushing the global price level very low. There were opinions that it was not suitable in such situation to react to a slowdown in inflation by lowering rates and thereby sending an additional demand impulse to the economy. Such a reaction would have been suitable provided that declining inflation was the cause of the drop in demand. It was also mentioned that undershooting the target in this situation would not decrease monetary policy's credibility. In reaction, it was said that monetary policy's primary objective should always be to reach the inflation target.

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

Author of the Minutes: Katerina Smidkova, Adviser to the Bank Board

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