Minutes of the Bank Board Meeting on 28 June 2012

Present at the meeting: Miroslav Singer, Mojmír Hampl, Vladimír Tomšík, Kamil Janáček, Lubomír Lízal, Pavel Řežábek, Eva Zamrazilová.

The meeting opened with a presentation of the fourth situation report assessing the new information and its effect on the fulfilment of the risks to the inflation forecast contained in the third situation report. The risks to the forecast were tilted towards higher headline inflation and lower monetary-policy relevant inflation amid a lower outlook for interest rates. Headline inflation had gone down by 0.6 percentage point to 3.2% in May and was thus 0.2 percentage point lower than forecasted. The decline in inflation had been due primarily to lower-than-expected food prices and fuel prices. Lower interest rates were also being fostered by the situation abroad, in particular a lower interest rate outlook in the euro area and lower prices of some commodities, most notably oil. Domestic economic activity was also anti-inflationary by comparison with the baseline scenario, as GDP had fallen by 0.7 percentage point year on year in 2012 Q1 whereas the forecast had predicted stagnation. Practically all components of GDP had been lower than forecasted. Only net exports had contributed significantly positively to economic activity. In contrast to the slowing growth in domestic demand, the main inflationary factors were depreciation of the koruna and higher-than-expected average wage growth, reflected in higher nominal unit labour costs. A more detailed discussion of the risks to the inflation forecast can be found in the commentary on the Graph of Risks to the Inflation Projection (GRIP).

In the discussion that followed the presentation of the situation report, the consensus was that the demand pressures from the domestic economy were currently very subdued and would remain anti-inflationary. The board members also agreed that the fiscal (restrictive) alternative scenario was currently more likely to materialise than the baseline scenario given the continuing fiscal consolidation and the increased probability of growth in indirect taxes. This alternative scenario was predicting a lower interest rate path than the baseline scenario. However, doubts were expressed about whether, in supporting economic growth, monetary policy was capable of sufficiently offsetting the impact of fiscal restriction and worse growth sentiment. In connection with fiscal policy, mention was also made of VAT collection, which was lower than expected despite an increase in the tax rate. This was evidently linked with the “frontloading” effect and with the sharp decline in private consumption of households in the context of GDP use. This decline is the deepest since the 1996/1997 crisis.

It was said several times that the now major uncertainties associated with the external situation were growing further. These uncertainties were, among other things, negatively affecting the expectations of domestic economic agents. Deteriorating growth prospects in the EU and other economies were also being reflected in commodity prices, which were significantly lower than assumed in the forecast. It was also mentioned that the decline in commodity prices may imply downward second-order effects on demand for Czech exports from commodity-exporting countries.

In the discussion of the external situation, several board members emphasised the risk of the weaker exchange rate, which was leading to generally easier monetary conditions and was currently the main inflationary factor. The majority of the board members agreed that this depreciation primarily reflected external factors, changes in sentiment around the euro area and globally elevated risk aversion. It was also said that the current depreciation was giving rise to doubts about the forecast assumptions of equilibrium exchange rate appreciation and real convergence of the Czech economy. Some of the board members expressed concerns about the interest and exchange rate components of the monetary conditions having opposite effects. A long-lasting depreciation of the koruna, an outflow of capital and an increase in the upside risks to inflation might occur in reaction to a reduction of interest rates. However, this was outweighed by the argument that an interest rate reduction was already expected and was therefore already reflected in the exchange rate. It was also mentioned that the current depreciation was at least partly offsetting the negative evolution of domestic GDP.

The Board also discussed monetary policy transmission in conditions of low interest rates. Some of the board members expressed doubts about the effectiveness of this transmission and about whether a minor change in monetary policy rates would lead to higher lending activity and to an economic recovery. In this context, it was mentioned that the barrier to growth was not a shortage of bank funds, but insufficient demand for loans with reasonable risk. By contrast, the stability of the spread between short-term market rates and monetary policy rates and the observed decline in client interest rates on loans were used to argue that monetary policy transmission was functioning despite the low rates. Most of the board members expressed their belief that the transmission mechanism on the credit market was functioning, as were the standard economic mechanisms whereby businesses compare the cost of capital and the return on investment in their decision-making processes. It was also said that a 25 basis point change in monetary policy rates implies a greater reduction in rates in a low interest rate environment than in a situation of higher interest rates. It was also noted that any reduction in the functioning of transmission should, on the contrary, lead to an even more aggressive monetary policy response.

The Board then discussed inflation expectations. Mention was made of the possible risk that higher headline inflation due to the higher indirect taxes and weaker exchange rate would give rise to higher inflation expectations. Such expectations could affect wage bargaining and the second-round effects of the changes to indirect taxes. In this context, the Board discussed the observed higher wage growth and the related rise in unit labour costs in the first quarter of this year, which were signalling potential cost pressures. However, it was also mentioned that the rise in nominal unit costs was largely due to declining productivity and the unexpected contraction of the economy. The prevailing view was that the economy did not currently have room for higher wage growth given the pessimism of domestic economic agents about the future economic situation.

At the close of the meeting the Board decided by a majority vote to lower the CNB two-week repo rate by 0.25 percentage point to 0.50%, effective 29 June 2012. At the same time it decided to lower the Lombard rate by the same amount, to 1.50%. The discount rate was left unchanged at 0.25%. Four members voted in favour of this decision: Miroslav Singer, Mojmír Hampl, Vladimír Tomšík and Lubomír Lízal. Three members voted for leaving interest rates unchanged: Kamil Janáček, Pavel Řežábek and Eva Zamrazilová.

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