Minutes of the Bank Board Meeting on 30 March 2006
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 was presented with the March situation report, which analysed the new information and subsequently re-assessed the economic risks relating to the January forecast.
At 2.8%, inflation in February had been in line with the forecast. The downside risks to inflation associated with the January forecast had eased compared to February. Inflation would fluctuate below the inflation target in 2006 and then increase in 2007 as a result of harmonisation changes to taxes. The tightening of the monetary conditions through the exchange rate component had halted. The rapid money aggregate growth was continuing.
The most significant new information had been the high GDP growth figures for the final quarter of 2005 and the revisions to the previous quarters' data. Economic growth had been considerably higher in 2005 than predicted in the January forecast and than suggested by the leading indicators. Although the growth had exceeded the projected rate, no demand-pull inflationary pressures were emerging in the economy. The hypothesis was put forward that potential (non-inflationary) output might have risen faster than the January forecast had predicted. Another factor was that the economic growth was being driven by exports and investment, while household demand - which, if it were to rise quickly, might increase the pressure on inflation - was rising slowly.
After the presentation of the situation report, the Board discussed the new distribution of the risks relating to the January forecast and the implications of that new distribution for monetary policy. The easing of the downside risks of the inflation forecast had been caused primarily by a correction of the exchange rate of the koruna, by expectations of a rate increase in the euro area and probably also by the high economic growth in 2005. The Board agreed that the downside risks were smaller than in February and that the monetary policy rate settings were in line with economic developments.
The Board paid considerable attention to the new GDP growth figures for 2005. The Board stated that the economic growth had exceeded expectations and that the factors underlying it needed to be analysed carefully. Several hypotheses were put forward in this regard. It was said that the higher growth reflected structural changes in the economy and that these changes were leading to higher growth in potential output. The hypothesis was also expressed that the transmission of demand pressures to inflation depends on the structure of the growth and that export- and investment-led growth can generate far lower inflation pressures than growth driven by household consumption. It was also said that the GDP growth figures might partially reflect a change in the GDP calculation methodology or some other one-off factor. It was possible that a future data revision might alter the growth profile. The opinion was also expressed that the high growth of the economy might partially reflect the effect of the worsening terms of trade on the value of net exports at constant prices. It was also said that the GDP growth figures were difficult to interpret, because other economic indicators were not developing in line with the assumption of high growth. It was said that it would also be appropriate to analyse the evolution of real gross domestic income, which better corresponds to the terms of trade and inflation. In this context, it was also said several times that the GDP figures were reliable.
The Board went on to discuss the link between economic growth and demand-pull inflation. It was said repeatedly that the pick-up in GDP growth was not passing through to demand-pull inflation as significantly as might be expected using the standard demand model. The board members saw the causes of the weak demand pressure on inflation in several areas. It was said repeatedly that the reason was weak growth in household consumption, reflecting sluggish growth in disposable income. The view was also expressed that, in an environment of increasing international competition, no significant inflationary wage pressures could be expected going forward, either. It was said that the rising competition in the labour market resulting from labour migration into the Czech Republic was offsetting the low flexibility of the domestic labour market and easing the wage pressures on inflation. In this context it was also said that in a small open economy, demand pressures might initially show up in higher import growth rather than directly in inflation.
During the discussion of the link between growth and inflation the Board also debated the effect of fiscal policy on the economy. It was said that fiscal policy may be increasing the volatility of the economy. The fiscal impulse generated by some of the plans under discussion might in the short run foster appreciation of the currency and at the monetary policy horizon conversely create depreciation pressures. It was also said that the labour market might be affected as well, since higher social benefits might lead to a fall in employment. It was said that the high economic growth should not be an incentive for increased fiscal expansion and that, on the contrary, it should be exploited for a necessary fiscal correction. It was said repeatedly that failure to respect this rule would bring about a difficult-to-sustain fiscal trend that would further increase the volatility of the economy.
The Board also discussed the international context. It was said repeatedly that international comparison reveals that the Czech economy is developing rather atypically, as countries undergoing similar structural changes accompanied by currency appreciation typically experience rising consumer optimism and rising household demand. This dissimilarity was making economic analysis more difficult. It was also discussed whether the recent movement of the exchange rate was a reflection of developments in the region or whether it reflected the fact that the koruna is becoming a currency used by financial investors to finance their transactions. Attention was drawn to the expected development of the balance of payments, which does not rule out the net inflow of foreign direct investment being negative in 2006. It was said that this might also create pressure for a depreciation of the koruna. It was mentioned several times that the expected growth in foreign rates was an important factor in assessing the risks of the January forecast.
At the end of the meeting the Board decided unanimously to leave the two-week repo rate unchanged at 2%.
Author of the minutes: Kateřina Šmídková, Adviser to the Board
Please send any comments to the author at katerina .smidkova @cnb .cz