Minutes of the Bank Board Meeting on 27 July 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 discussed the July situation report containing the new macroeconomic forecast. According to the forecast, the economy was currently above the non-accelerating inflation level of output, whose rate of growth had been increased compared to the April forecast. The estimate of the output gap had been revised upwards relative to the previous forecast, fostering an increase in the inflation forecast. The inflation forecast also reflected growth in indirect taxes, to whose first-round effects monetary policy does not react.

At the monetary policy horizon, inflation was thus close to the upper boundary of the toleration band of the inflation target. The higher forecasted inflation was due to slightly higher growth in administered prices, to a rise in food prices caused, among other things, by growth in agricultural producer prices, and to higher fuel prices, reflecting the rise in oil prices. By comparison with the April forecast, the prediction for adjusted inflation excluding fuels was lower in the short term, primarily in response to an initially stronger exchange rate. In the longer term, conversely, it was higher owing to demand-pull inflation pressures caused by the revision of the output gap and owing to the second-round effects of the higher energy prices.

The economic growth forecast was higher for 2006 but slightly lower for 2007. Growth in net exports and growth in investment, linked, among other things, with the past inflow of foreign direct investment and the creation of new export facilities, would continue to have a positive effect. This factor would continue to favourably influence the Czech economy going forward. Expected growth in wages and employment would lead to a pick-up in household consumption growth.

Consistent with the July forecast and its assumptions was a gradual rise in interest rates.

After the presentation of the situation report, the Board discussed the uncertainties and risks associated with the forecast. The board members agreed that the revision of the current position of the economy in the business cycle was an uncertainty of the forecast. This was meanwhile one of the main factors affecting the forecast for growth of adjusted inflation excluding fuels. There was some discussion of the distribution of the current high economic growth between growth in the non-accelerating inflation level of output and growth in the output gap. Some of the board members expressed the view that the increase in the output gap in the forecast was too pronounced as compared to the observed adjusted inflation and other economic figures. Hence, the Board should defer raising interest rates until there were clearer signs of demand-pull inflationary pressures. Against this, opinions were expressed that the widening of the output gap was consistent with the evolution of related economic indicators, so the rise in interest rates should not be put off. Such an increase was also in line with developments abroad and with alternative analyses of the economy.

The Board also discussed the labour market situation and its impacts on wage and related inflation pressures going forward. The majority of the board members agreed that no such pressures were currently evident. In this context, particular mention was made of the fall in nominal unit wage costs, the growth in labour productivity and the rise in the number of hours worked. Against this, some of the board members identified the possibility of a rise in such pressures, mainly due to growing nominal wages, increased demand for work and falling unemployment. It was also said, however, that the openness of the Czech economy to foreign workers was a factor slowing wage growth and reducing this risk.

The board members assessed the uncertainty regarding the effects of fiscal policy going forward on both the revenue and, in particular, expenditure side of the public budgets. It was said that this was a major uncertainty and that it was impossible to determine its direction of effect in advance.

The Board also discussed the risk of appreciation of the exchange rate. The opinion was expressed that an increase in interest rates might lead to a strengthening of the exchange rate. Against this, it was said that the exchange rate response should not be all that strong, as an interest rate increase was expected.

After discussing the situation report, the Board decided by a majority vote to raise the two-week repo rate by 0.25 percentage point to 2.25% with effect from 28 July 2006. At the same time it decided to increase the discount rate and Lombard rate by the same amount, to 1.25% and 3.25% respectively. Four board members voted in favour of this decision, and three members voted for leaving rates unchanged.

Author of the minutes: Michal Hlaváček, Adviser to the Board

Please send any comments to the author at michal .hlavacek @cnb .cz