Minutes of the Board Meeting on 31 March 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 meeting opened with a presentation of the March situational report, which concentrated on assessment of new information and its implications for the risks associated with the fulfilment of the January macroeconomic forecast. The new information indicated that, in relation to the January forecast, the risks were shifting in an anti-inflationary direction.

At 1.7%, February inflation was slightly lower than predicted in the January forecast. Downward deviations of the reality from the forecast were recorded for food prices and adjusted inflation excluding fuels. Regulated prices deviated upwards from the forecast.

Year-on-year GDP growth was higher in 2004 Q4 compared to the January forecast. Favourable net exports accounted for the bulk of the deviation. Conversely, household consumption growth was more sluggish than predicted in the January forecast, and the year-on-year decline in government consumption was greater than expected. Growth in gross fixed capital formation was also lower. Investment nonetheless maintained a solid rate of growth. The leading growth indicators signal continuing economic recovery.

The Board followed the presentation of the situational report with a discussion. The board members agreed that the new information did not signal any major change in the assessment of the economy by comparison with the previous monetary policy meeting. It had been confirmed that the risks of the January forecast were accumulating on the anti-inflationary side. These anti-inflationary risks included in particular the development of the exchange rate, which was continuing to deviate towards appreciation from the assumptions of the January forecast. They also included the evolution of food prices, owing to the development of agricultural producer prices and the competition in the agricultural and food product markets. In the remainder of this year, the contribution of regulated prices to inflation would probably be smaller than forecasted. Long-term inflation expectations were also at a relatively low level. An upside risk was the evolution of prices of oil and other selected commodities, although this had so far been largely offset by the exchange rate. An improvement in labour market indicators and employment growth was expected; this could boost the rate of growth of private consumption via an improvement in household income. So far, however, the change was too small to present a significant inflationary risk.

The Board turned its attention to assessing the GDP growth figures for 2004 Q4 and the revised figures for previous quarters. The effect of the new figures on inflation could not be interpreted unequivocally. Economic growth had been higher than forecasted without generating inflationary pressures. This could signify a wider-than-forecasted negative output gap due to higher than expected growth in potential output. The estimate of potential GDP growth was thus viewed as a major uncertainty of the forecast. The structural view of GDP growth simultaneously indicated that the growth last year had been driven primarily by net exports and investment, whose direct impact on consumer price inflation is smaller. Growth in consumption, i.e. the component of GDP that has a direct influence on consumer prices, had been lower than forecasted. The persisting low inflation hence did not necessarily reflect solely an absence of demand pressures, but might also be due to the aforementioned structural effects.

The Board then discussed the settings of the monetary conditions. It was said that the appropriate response to the new information confirming the persistence of anti-inflationary risks was a reduction of interest rates. Such action would be consistent with the logic of the inflation targeting regime and with the current inflation target. A decrease in interest rates could boost demand slightly, ease the exchange rate pressure on the corporate sector somewhat, and reduce the risk of continued stronger appreciation. The opinion was also expressed that should new information further accentuate the disinflationary risks, which would thereafter probably be reflected in the April forecast, it would be possible to consider reducing interest rates by more than 0.25 of a percentage point.

However, it was also pointed out that the interest rate component of the monetary conditions was already easy and interest rates were stimulating for the economy. That could imply an increase in risks in the financial stability area going forward, especially given the accelerating growth in lending and developments in the property market. It was also said that it was not appropriate to try to fully offset past exchange rate swings with a movement in interest rates, nor was this even possible given the different lags in the effect of the exchange rate and interest rates on the economy. Such an approach would be backward-looking and would mean excessive central bank interest rate policy activism. Another argument in favour of caution as regards lowering interest rates was that the low current and expected inflation reflected not only demand factors, but also structural ones, and monetary policy had limited options for countering these anti-inflationary pressures. In the event of continuing exchange rate appreciation and disinflationary cost factors, it was likely that inflation would remain relatively low in the longer term despite a monetary policy response.

In this context, the Board discussed the parallels and differences between the current exchange rate and economic situation and that in 2001-2002. It pointed out that the current rate of appreciation of the exchange rate vis-à-vis its equilibrium level was lower than at the end of 2001 and in the first half of 2002, and that the corporate and financial sectors were in a different situation. The impact of the exchange rate on the economy therefore should not be as significant as during the previous appreciation episode.

After discussing the situational report, the Board decided unanimously to lower the CNB two-week repo rate by 0.25 percentage point to 2%, effective from 1st April 2005. At the same time it decided to reduce the discount rate and Lombard rate by the same amount, to 1% and 3% respectively. All seven members voted in favour of this decision.

Author of the Minutes: Aleš Čapek, Adviser to the Board

Comments are welcome on the following email address: Ales.Capek@cnb.cz