Minutes of the Bank Board Meeting on 26 January 2006
Present at the meeting: Z. Tůma (Governor), L. Niedermayer (Vice-Governor), M. Singer (Vice-Governor), J. Frait (Chief Executive Director), R. Holman (Chief Executive Director), P. Řežábek (Chief Executive Director). Minister of Finance B. Sobotka was also present for part of the meeting.
The Board was presented with the January situation report, containing the new forecast for inflation and other macroeconomic variables.
The new forecast confirmed the low-inflation nature of the current economic recovery. By comparison with the October forecast, the prediction for inflation this year had been lowered and that for GDP growth had stayed unchanged. The decrease in expected inflation for this year had come in response to the lower-than-predicted inflation recorded at the end of last year, to the firmer exchange rate, and to a revision of the estimated impacts of the changes to excise duties. It was assumed that economic growth would continue to be driven by improving export performance, that household consumption would pick up, owing to cyclical growth in employment, and that the buoyant growth in investment demand would continue. The forecast assumed a roughly neutral effect of budget policy on economic growth this year and a slightly positive contribution next year.
The model forecast was based on partially revised estimates of the equilibrium variables that co-determine the cyclical position of the economy and the effect of the monetary conditions. Compared to the previous forecast, the estimate of the equilibrium real interest rate in the model had been lowered and the estimated rate of equilibrium real appreciation had been raised, with an assumption of a gradual decline in that rate going forward. As a result, the estimated past effect of the interest rate component of the monetary conditions had become tighter, while the previous effect of the real exchange rate was estimated to have been less tight.
Consistent with the January forecast was a gradual rise in interest rates, this being conditional, inter alia, on growth in interest rates abroad and broad stability of the exchange rate at roughly the level recorded at the end of last year.
After the presentation of the situation report, the Board discussed the new forecast and the risks thereto. The Board agreed that the risks were skewed to the downside. The main sources of risk were the evolution of the exchange rate and the uncertainty surrounding the rate of increase of interest rates abroad. There was a consensus, however, that foreign interest rates are by no means the sole determinant of monetary policy, since the exchange rate is affected by numerous other factors. During the discussion, concerns were raised that although the revisions to the model had improved its behaviour as regards predicting the exchange rate, it was unclear whether they would improve its ability to predict inflation. On the other hand, it was said that the revisions might have been the appropriate response to the new information on the development of the economy and that they preserved the consistency of the prediction. It was agreed that this issue would be analysed on an ongoing basis and that the Board would continue to pay attention to it.
In the discussion on the exchange rate, the Board agreed that the recent rate of appreciation was unsustainable with regard to the real economy. However, the opinion was expressed that producers had so far been able to cope with the appreciation. Against this it was argued that some worsening of exporters' situation was apparent from the latest data on corporate financial results.
It was mentioned in the debate that a halt in the appreciation of the exchange rate and a subsequent correction was one of the possible scenarios, despite the sentiment to the contrary prevailing among domestic analysts. In the discussion of the uncertainty surrounding the exchange rate going forward, attention was drawn to the potentially sizeable effect of the deficit on the income account of the balance of payments. It was also said that monetary policy should not respond hastily to short-term exchange rate swings and that the exchange rate is a highly volatile variable. On the other hand, the view was repeatedly expressed that the factors underlying the appreciation might be more permanent in nature and that the appropriate monetary response to such a shock would be to lower monetary policy interest rates.
Attention was repeatedly drawn to the low-inflation nature of the Czech economy. The very low level of core inflation was mentioned, as was the fact that the prediction of so-called monetary policy inflation, adjusted for the first-round effects of taxes, was below the inflation target at the monetary policy horizon. It was also said that average inflation had been below the target throughout the past four years, and there was a discussion of the potential impacts of the long-running undershooting of the inflation target on inflation expectations and expectations regarding the nature of monetary policy. The opinion was expressed that a temporary easing of monetary policy might be appropriate in this context in order to restore the credibility of the inflation target. On the other hand, attention was drawn to the problems generated by efforts to hit the inflation target in a situation of continuing appreciation of the exchange rate.
The Board turned its attention to the surprisingly good employment trend. There was broad agreement that the downside of this otherwise positive development was that the registered unemployed were not being employed to any greater extent. The link between the comparatively low growth in labour costs and the high and still growing proportion of non-residents in the rising employment growth was discussed.
During the debate, the members also touched on developments in the property market. The concern was raised that the likely transfer of construction work to the higher tax rate in 2008 might cause disequilibrium in this market in the interim. However, the expectations of slackening demand in the property market as suggested by survey results were also mentioned.
There was a consensus that the effect of budget policy was a source of uncertainty for monetary policy decision-making. In the context of a rapidly growing economy, there was a risk that the relatively reasonable fiscal path last year would not continue in 2006. Instead, the government might this year fully use the scope provided by the convergence programme and the approved budget in order to increase the budget deficit, and furthermore might also draw on the considerable reserves carried over from 2005.
After discussing the January situation report, the Board decided by a majority vote to leave the two-week repo rate unchanged at 2%. Four members voted in favour of this decision, and two members voted for lowering interest rates by 0.25 percentage point.
Author of the minutes: Martin Cincibuch, Adviser to the Board
Please send any comments to the author at Martin.Cincibuch@cnb.cz