Minutes of the Bank Board meeting on 2 November 2023

Present at the meeting: Aleš Michl, Jan Frait, Eva Zamrazilová, Tomáš Holub, Karina Kubelková, Jan Kubíček, Jan Procházka. Minister of Finance Zbynek Stanjura was present at the open part of the meeting.

The meeting opened with a presentation of the seventh situation report and the new macroeconomic forecast. According to this forecast, inflation would fall to close to the 2% target at the start of next year and stay there over the monetary policy horizon. Consistent with the baseline scenario of the forecast was a gradual decline in interest rates from 2023 Q4 onwards.

The Bank Board assessed the risks of the forecast and the uncertainties of the outlook as being significant and tilted to the upside. The threat of inflation expectations becoming unanchored was the main upside risk to inflation. This could lead to increased wage demands and stronger repricing at the start of next year, which would imply inflation being more markedly above the target throughout next year. A longer effect of expansionary fiscal policy was also an inflationary risk. By contrast, a stronger-than-expected downturn in economic activity in Germany and the potential impacts of globally tightened monetary and financial conditions were downside risks to inflation. The uncertainties of the outlook included the future course of the war in Ukraine and the Middle East, the prices of energy, and the future monetary policy stance abroad.

At the start of the Bank Board’s discussion, Aleš Michl noted that the new Board’s chosen strategy since July 2022 in the form of high and stable interest rates and a strong koruna – which had led to the creation of the tightest monetary conditions in 20 years – had worked and had clearly contributed to inflation declining from 18% in September 2022 to 6.9% in September of this year. The new forecast saw inflation falling significantly further next year. However, the fight against inflation must continue. It was vital to restore long-term price stability as soon as possible, i.e. to do everything to bring inflation down to levels close to 2% in the long run. In this regard, Eva Zamrazilová and Jan Procházka pointed out that, as regards the structure of inflation, the forecast predicted that the decline in inflation next year would be due in large measure to volatile items in the form of food and energy prices, the paths of which were subject to a large degree of uncertainty.

Turning to energy prices, the board members repeatedly identified the Energy Regulatory Office’s announcement of an increase in the administered component of the price of electricity as an upside risk to inflation. The announced increase was approximately in line with the autumn forecast in terms of magnitude, but according to Eva Zamrazilová it was evidently not in line with the expectations of some firms, which, with their statements, were creating room for a further wave of price hikes. According to Karina Kubelková, materialisation of the still elevated inflation expectations among households and firms could cause inflation to be more persistent in the period ahead, especially if firms were to reflect the growth in costs by raising their prices rather than reducing their margins. The Board repeatedly mentioned the impacts of the deteriorating geopolitical situation as another upside risk to energy prices, particularly with regard to the future course of the war in the Middle East.

The Board also discussed the supply of money in the economy in depth. Among other things, Eva Zamrazilová regarded the M3 money aggregate, which in the Czech Republic had been growing at double-digit rates and at the fastest pace in Europe for several months, as an inflationary warning signal. By contrast, Tomáš Holub attached considerably less weight to this, interpreting it more as reflecting a change in the portfolios of non-monetary financial institutions. Jan Kubíček on the one hand agreed that this phenomenon was happening, but on the other hand felt that the changes in portfolios were not sustainable, as collective investment funds would not keep holding hundreds of billions of koruna on bank accounts when interest rates came down. In this regard, Aleš Michl noted that loans to government and loans to the private sector were among the main sources of M3 growth. While growth in loans to the private sector had been reined in by tight monetary policy – such loans had risen by just 4.7% year on year in August – he regarded loans to central government, which had gone up by 12.8% in the same period, as an upside risk to inflation.

A large part of the debate was devoted to the monetary policy stance and the future interest rate reduction strategy. With regard to this, the board members repeatedly commented on the potential stronger repricing of goods and services in January. This risk had been captured in an alternative scenario, which implied interest rates staying at their current level until the end of the first quarter of next year. There was a consensus that in an environment of elevated inflation expectations, the optimal response for achieving the inflation target was to keep rates unchanged for longer. Tomáš Holub noted that if, in February, the January inflation reading turned out to be already close to 2% and interest rates were still at 7%, the subsequent interest rate reduction cycle would have to start to be implemented in larger steps. Jan Procházka also drew attention to the fact that, as regards prices of certain seasonal consumption basket goods such as school supplies and children’s shoes, which are typically repriced before January, the risk of sharper growth in prices had not been confirmed so far. Against this, Eva Zamrazilová pointed out that the inflation figure for October, to be published on Friday 10 November, would be higher than the September reading mainly because of the technical effect of last year’s reduced base. This could revive inflation expectations, given their evidently adaptive nature, and it might then prove difficult to lower interest rates any time soon. Eva Zamrazilová and Jan Kubíček also mentioned the easing of monetary conditions via the exchange rate of the koruna, which had weakened by an amount equivalent to an interest rate cut of around 0.75 percentage point since the last forecast, as an argument for leaving rates unchanged. According to Jan Kubíček, the koruna could moreover weaken further as a result of decreasing foreign currency borrowing due to a narrowing interest rate differential caused by rising euro area interest rates, which he saw as an upside risk to inflation. According to Jan Frait, the action taken by central banks to date was proving effective and helping to weaken the demand-pull inflation pressures. Tight monetary and financial conditions were now prevailing, especially in developed countries. Expectations that they would stay that way for longer were being reflected in economic agents’ behaviour in a way that should also be anti-inflationary.

The board members also repeatedly commented on the impacts of monetary policy on real economic activity. Tomáš Holub noted that in a situation of an impending restoration of price stability, monetary policy decision-making should again begin to take into consideration the real economy, which, given stable nominal interest rates, could be exposed to excessively tight monetary conditions. Eva Zamrazilová responded that foreign-controlled companies accounted for approximately three-quarters of Czech exports, which were the backbone of the Czech economy. Such companies were far more dependent on euro area interest rates than on domestic monetary conditions. Keeping interest rates at the present level for longer, for example until the start of next year, should therefore not pose a risk to the export performance of the Czech economy. This was supported by Jan Kubíček and Jan Procházka, who identified some features of the current domestic economy at the end of a restrictive period as surprising. These features included a still very tight labour market and virtually non-existent cyclical unemployment. In this context, repeated mention was made of the discrepancy between the estimated negative output gap and the still tight labour market. Jan Frait, Eva Zamrazilová and Jan Procházka also identified labour market indicators as more important. These were observed variables, whereas the position of the economy in the business cycle was just a model-based estimate.

In a discussion of the effect of domestic fiscal policy, Jan Frait said he did not consider the current state of public finances to be a source of immediate risks, and, in his opinion, the state budget should not have an inflationary effect next year. Tomáš Holub supported this view. By contrast, Karina Kubelková and Jan Kubíček regarded the projected general government deficit of 1.6% of GDP for 2024 as optimistic and saw the likely non-fulfilment of this projection as an additional upside risk to inflation. Jan Kubíček additionally pointed out that even the Ministry of Finance itself was not predicting such a favourable public finance outcome. In this regard, Aleš Michl identified a reduction of the government debt ratio as a key condition for taming inflation.

The Board decided to leave interest rates unchanged. The two-week repo rate remains at 7%, the discount rate at 6% and the Lombard rate at 8%. Five members voted in favour of this decision: Aleš Michl, Eva Zamrazilová, Karina Kubelková, Jan Kubíček and Jan Procházka. Two members, Jan Frait and Tomáš Holub, voted for reducing rates by 25 basis points.

Author of the minutes: Martin Motl, Monetary Department