Minutes of the Bank Board meeting on 1 August 2019
Present at the meeting: Jiří Rusnok, Marek Mora, Tomáš Nidetzký, Vojtěch Benda, Oldřich Dědek, Tomáš Holub, Aleš Michl.
The meeting opened with a presentation of the fifth situation report and the new macroeconomic forecast covering the horizon up to the end of 2021. Headline inflation had risen slightly to 2.8% in 2019 Q2. The brisk growth in prices in recent months had been due mainly to core inflation, which had reflected persisting strong domestic pressures. Inflation had also been affected by continued high growth in administered prices and recently also by stronger growth in food prices. GDP growth had picked up slightly to 2.8% in 2019 Q1. Household consumption had made the biggest contribution, mainly reflecting solid growth in disposable income. An unwinding of the negative contribution of change in inventories had offset reduced contributions of fixed investment and government consumption. Total export and import growth had slowed considerably, while the contribution of net exports had turned slightly negative.
Inflation would stay above the CNB’s 2% target, but still within the tolerance band, in the quarters ahead. This would continue to reflect persisting strong domestic inflation pressures and high growth in administered prices and food prices. Inflation would start to decrease at the start of next year, owing to the previous monetary policy tightening and an unwinding of the currently high growth in administered prices. Headline inflation would approach the target over the monetary policy horizon, i.e. in the second half of next year. The decrease in inflation would be slowed by the impacts of changes to indirect taxes, which would affect annual inflation throughout next year. The Czech economy would grow by 2.6% this year and accelerate to 3% over the next two years. Growth in economic activity would continue to be driven by all components of domestic demand except inventories. Robust growth in household consumption would reflect continued, albeit gradually slowing, growth in household income. Growth in private investment activity would remain solid over the entire forecast horizon, owing to high capacity utilisation. Government investment expenditure would also grow further, supported by drawdown of EU funds. Net exports were hindering economic growth this year but would make a slightly positive contribution to economic growth next year. According to the forecast, the koruna would gradually appreciate, owing mainly to a significantly wider positive interest rate differential vis-à-vis the euro area and to continuing real convergence of the Czech economy to the euro area countries linked with rising labour productivity. Consistent with the forecast was a modest rise in domestic market interest rates initially, followed by a decline in 2020.
In the discussion that followed the presentation of the situation report, a majority of the board members assessed the balance of risks to the forecast at the monetary policy horizon as being slightly anti-inflationary. The Board agreed that the risk of a more pronounced slowdown in demand growth in the Czech Republic’s main trading partner countries is the main factor acting in this direction. In this discussion, repeated mention was made of the forecast’s assumption of a relatively rapid recovery in external economic activity, which seemed uncertain, especially in light of the worsening leading indicators. In this context, it was also noted several times that the main world central banks would now go down the road of easing monetary policy, as the US central bank had already decided to cut interest rates and the ECB had been communicating its readiness to ease monetary policy further. Against this, it was said that despite the growing number of warning signals from the global economy, the economic growth forecasts of most renowned international institutions are still relatively optimistic. In this connection, the sensitivity scenario of half the baseline rate of growth in the euro area next year was repeatedly discussed and referred to by a majority of the board members in the discussion of the external risks and uncertainties. Besides this, the impacts of protectionist measures in global trade and a disorderly Brexit remained sources of external uncertainty.
In connection with developments abroad, it was mentioned several times that the growing pessimism around the world had not yet spilled over significantly to the Czech economy, in which strong fundamental inflation pressures persisted. On the other hand, the opinion was expressed that if the situation abroad continued to deteriorate, these negative impacts could not be avoided in the future, given the very high openness of the Czech economy and its close trade links with the euro area. The Board also agreed that the Czech economy is in a more comfortable situation than the euro area from the macroeconomic perspective. It was said that the two-week repo rate is 2%, inflation is in the upper half of the tolerance band around the 2% target and the economy is close to its potential.
The Board devoted part of its discussion to the question of credibility and the question of the interpretation of fulfilment of the 2% inflation target. The opinion was expressed that in non-standard situations, when the external uncertainties are elevated, the objective of price stability can be regarded as fulfilled provided that inflation is inside the tolerance band around the target. For this reason, part of the Board did not see any risk of a loss of credibility or a weakening of the anchoring of inflation expectations, and hence did not feel any need to react to each and every minor deviation of inflation from the 2% target within the tolerance band. In this regard, it was repeatedly mentioned that a continued modest overshooting of the inflation target was unlikely to lead to a rise in inflation expectations. This risk is all the smaller in the current global context, where, on the contrary, concerns about low inflation and a longer-term undershooting of the inflation target are prevalent among central bankers around the world. Against this, the opinion was expressed that monetary policy should react actively to changes in the economic situation and not try to “sit out” the necessary interest rate adjustment. In this context, mention was made of the risk of overshooting the upper bound of the tolerance band if interest rates were left unchanged, as the forecast implied an initial slight increase in interest rates followed by a decline with the passage of time in 2020. It was also said that the interest rate path had had a similar shape in the January 2008 forecast. At that time, the initial increase in interest rates had represented the completion of a rate increase cycle aimed at supporting the credibility of the inflation target and the anchoring of inflation expectations in a situation of an overheated economy and strong domestic price pressures. The subsequent interest rate decline – foreseen by the forecast – had been a forward-looking response to an economic cooling arriving from abroad. It was meanwhile emphasised that in 2008 inflation had been well above the upper bound of the tolerance band. The current initial increase in interest rates is thus much less necessary for maintaining the credibility of the target than it had been then.
The Board also devoted a large part of its discussion to the impacts of expected changes to indirect taxes. In this connection, it was noted that a monetary policy escape clause was normally applied to the first-round impacts of changes to indirect taxes. This time, however, immediate second-round impacts – to which monetary policy does usually react – were playing a much more significant role. In this regard, it was said repeatedly that the immediate second-round impacts might reflect on the one hand the overall cyclical situation of the economy, but on the other hand also the oligopolistic structure of the market or the fact that prices are usually more sticky downwards than upwards. It was mentioned that while the increase in excise duties would pass through fully to prices, the decrease in VAT rates on some goods and services would conversely be used – at least in the short term – to increase profit margins and not to reduce prices. Part of the Board agreed that the model response of interest rates due to the immediate second-round impacts of changes to indirect taxes was not grounds for changing interest rates at today’s meeting. It was also said that if the central bank’s reaction function was defined not as t + 4 quarters, but as t + 6 quarters, the expected tax changes would no longer have a direct effect on the path of interest rates.
The transmission of short-term interest rates to yields at the longer end of the yield curve and also the widening interest rate differential between the Czech Republic and the euro area were also discussed during the meeting. In this regard, it was noted that the interest rate increase in May had only affected the short end of the domestic yield curve. With 5-year interest rates having fallen, this had caused its slope to be negative. The increase in the two-week repo rate was thus currently only affecting the short end of the yield curve, while its longer end was coming under pressure from the very accommodative monetary policies of key central banks. In this context, it was said that the drop in the longer end of the domestic yield curve was causing mortgage interest rates to decrease. The opinion was also expressed that a further rate increase in a situation of falling rates in the euro area could put the Czech economy at a competitive disadvantage, due to a rise in firms’ short-term operational funding costs. In the discussion, the opinion was also expressed that the significantly lower interest rates in the euro area might cause the Czech market to start moving into euro lending.
The Board also highly praised the changeover to the new g3+ core projection model and the related changes. The Board agreed that this change in model would further improve the quality of macroeconomic forecasts and thus further enhance the central bank’s credibility and international reputation. It was also said that thanks to the incorporation of a detailed foreign block, the new model would better capture the impacts of developments abroad on the very open Czech economy.
At the close of the meeting the Board decided unanimously to leave interest rates unchanged. The two-week repo rate remains at 2%, the discount rate at 1% and the Lombard rate at 3%. Jiří Rusnok, Marek Mora, Tomáš Nidetzký, Vojtěch Benda, Oldřich Dědek, Tomáš Holub and Aleš Michl voted in favour of this decision.
Author of the minutes: Martin Motl, Monetary Department