Minutes of the Board Meeting on 28 July 2005

Present at the meeting:

Z. Tůma (Governor) - departed during the meeting, L. Niedermayer (Vice-Governor), M. Erbenová (Chief Executive Director), J. Frait (Chief Executive Director), P. Řežábek (Chief Executive Director).

The Board discussed the July situation report, containing the new forecast for inflation and other macroeconomic variables, and the risks associated with the new forecast.

A low-inflation environment still persisted in the economy. The fall in headline inflation had halted at the end of the second quarter of 2005. The consumer price index had risen more year on year in June than predicted by the April forecast. The main reason for this had been higher-than-expected growth in administered prices (especially in telecommunications), food prices and fuel prices. Adjusted inflation excluding fuels had slowed as expected. The new inflation forecast had shifted upwards over the entire transmission horizon relative to the April forecast. Even after this correction, the forecast for inflation at the horizon of most effective transmission was just below the target.

The economy was in a growth phase of the business cycle. The GDP growth forecast was little changed from April. According to the new forecast, however, the growth would slacken over the next few quarters before picking up pace again. The output gap in the new forecast was narrowing rather more slowly, and would close in 2007. The unemployment rate was continuing to fall. By comparison with April, the forecast was based on an assumption of a smaller fiscal impulse, higher oil prices, a stronger dollar and lower rates in the euro area.

Consistent with the July forecast and its assumptions was interest rate stability over the next several quarters and a slight rise in rates thereafter.

After the presentation of the situation report, the Board discussed the new inflation forecast and economic developments. The Board agreed that the Czech economy was in a phase of low inflation and a growth phase of the economic cycle, and that the outlook at the horizon of most effective monetary transmission painted an equally stable picture.

There was also a consensus that the July forecast differed from the April forecast chiefly in that it took into consideration the impacts of cost shocks in the area of oil prices and administered prices. In this regard, it was said that the effect of the shocks on the forecast was fairly sizeable thanks to the fact that inflation in the Czech economy was nominally very low. It was also said that inflation in the Czech economy was low despite the fact that the cost shocks were significant. It was mentioned that one of the hypotheses explaining why this was so was the hypothesis on the formation of inflation expectations. Such expectations in the Czech economy reflected the transitory nature of the cost shocks, were increasing at a lower rate than would correspond to the size of the cost shocks, and hence were not generating pressure for inflation to accelerate. Another argument given in the discussion of the small observed impact of the cost shocks on inflation was the existence of adjustment mechanisms in the economy. The factors helping to depress the effects of cost factors on inflation included a fall in the share of wages in value added and partly also the appreciation of the koruna. It was also said that the rise in administered prices - one of the cost shocks increasing inflation - had also not fully passed through to prices. This may have been because this rise was curbing demand in other segments of the economy and hence partly reducing the demand pressure on inflation. This lower demand-pull inflationary pressure was to a large extent offsetting the effect of the original supply shock. In this context it was also noted that the demand-pull inflationary pressures were moreover being depressed by the smaller-than expected fiscal impulse.

The Board agreed that the risks of the July forecast were slight and symmetrical. The view was expressed that if the risks were at all skewed, they were skewed to the upside, but this skewing was very small and did not require any monetary policy response at the present time. On the other hand, it was said that these were not so much risks as just uncertainties of the forecast. It was said that the uncertainties of the forecast included, for instance, developments abroad, which may have been affected by the stronger-than-expected dollar and the faster-than-expected recovery in Germany. If these uncertainties were moved to the risk category, they would generate an upside skew to the risks of the July forecast. The view was repeatedly expressed that a change in expectations regarding the evolution of euro area rates would, via the interest rate differential, significantly affect the forecast assumptions. During the discussion of the risks and uncertainties, the view was expressed that the favourable figures on employment growth were two-thirds due to a rise in employment in the health and education sectors, and so the aggregate data painted an over-optimistic picture of developments in the labour market. It was also said that the positive outlook was based on an assumption of sustainable investment growth and that EU funds could help maintain the rate of growth of the economy. However, an increased inflow of such funds would not necessarily have an equally positive effect on the economy as efficient private investment, despite the attainment of a comparable rate of growth in the short run.

At the end of the meeting, the Board decided unanimously to leave the two-week repo rate unchanged at 1.75%.

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

Please send any comments to the author at Katerina.Smidkova@cnb.cz