Minutes of the Board Meeting on 28 April 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 large April situation report containing the new forecast for inflation and other macroeconomic variables.

The new forecast had revised the inflation prediction downwards compared to the January 2005 forecast. In addition to other effects, this was due above all to an anti-inflationary exchange rate effect and a worse economic outlook for the Czech Republic's major trading partners. According to the new forecast, inflation would be below the inflation target at the monetary policy horizon and would remain low until the end of 2006. During 2006 the forecast expected the anti-inflationary effect of import prices to unwind and demand-pull inflationary pressures to mount gradually. Inflation was expected to return to the target only in 2007. The easing of inflationary pressures in the forecast was due primarily to adjusted inflation excluding fuels and, in the shorter term, food price inflation.

The forecast was predicting continuing economic growth based on exports and investment. This notwithstanding, a tighter exchange rate would lead to a slowdown in export growth. By comparison with the January forecast, a rise in the fiscal impulse in 2005 was also predicted. At the same time, the rate of growth of output that generates no inflation pressures (potential output) had been revised upwards. These factors would cause the demand pressures linked with closure of the output gap to emerge later and with lower intensity compared to the January forecast.

Consistent with the baseline scenario of the forecast was a decline in interest rates in the period immediately ahead and flat interest rates thereafter.

After the presentation of the situation report, the Board discussed the new forecast and the associated risks. In the discussion, the view was expressed that once the anti-inflationary exchange rate shock had unwound and the output gap had closed, inflation at the monetary policy horizon might be higher than envisaged in the baseline scenario of the forecast. The forecast-consistent interest rates might then be excessively low. By contrast, the opinion was also expressed that further appreciation of the exchange rate was also a risk, as this might generate a further fall in inflation far below the target and towards values approaching deflation.

A consensus was reached that the downside and upside risks to the baseline scenario of the forecast were balanced overall. The possibility of a further growth slowdown in the Czech Republic's major trading partner nations compared to the assumptions of the baseline scenario, and continuing appreciation of the exchange rate, were considered to be the main downside risks to the inflation forecast. The possibility of higher-than-expected oil prices and the possibility of weaker pass-through of changes in the exchange rate into inflation were identified as upside risks to the inflation forecast. The hard-to-estimate effect of fiscal policy was viewed as a two-sided risk, increasing the overall uncertainty of the forecast.

The Board discussed the usefulness of lowering interest rates. Opinions were expressed that this would constitute excessively activist monetary policy, which could not offset the effects of the structural changes and cost shocks causing the decline in inflation. Against this was the argument - based on the logic of the forecast - that the open output gap, the higher growth in potential, the low initial inflation and the below-target inflation prediction allowed a reduction of rates. It was mentioned that the inflation forecast was heading below the target even on the assumption of a lowering of rates.

The Board agreed that the fact that lowering rates would take them below the level in the euro area did not constitute a significant factor in the decision on the level of rates.

Some board members expressed the concern that the low interest rate level might present a risk to financial stability. Opinions were also expressed that this was not a sufficient reason for leaving rates at their present level, as the interest rate reduction under discussion did not pose a risk of excessive credit growth.

After discussing the 4th situation report, the Board decided by a majority vote to lower the two-week repo rate by 0.25 percentage point to 1.75% with effect from 29 April 2005. At the same time it decided to reduce the discount rate and Lombard rate by the same amount, to 0.75% and 2.75% respectively. Four members voted in favour of this decision, and three members voted for leaving rates unchanged.

Author of the minutes: M. Cincibuch, Adviser to the Board

Comments are welcome on the following email address: Martin.Cincibuch@cnb.cz