Minutes of the Bank Board Meeting on 7 November 2013

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 seventh situation report and the new macroeconomic forecast covering the horizon up to the end of 2015. Headline inflation had fallen to the lower boundary of the tolerance band around the target in 2013 Q3, reaching 1.2% on average. Monetary-policy relevant inflation, averaging 0.4%, had dropped well below this boundary. In addition to tax changes, food prices and administered prices remained sources of inflation, although their contribution was decreasing. The domestic economy remained strongly anti-inflationary, with the previous depreciation of the koruna failing to offset this effect. Economic activity had been slowly recovering since 2013 Q2.

According to the baseline scenario of the new forecast, both headline and monetary-policy relevant inflation would drop to zero or be slightly negative at the start of 2014 and would then gradually return towards the target over the monetary policy horizon. Real economic activity would drop by 0.9% this year. It would grow by 1.5% next year thanks to rising external demand and the unwinding of the dampening effect of domestic fiscal consolidation. The growth would pick up further in 2015. Consistent with the forecast was a significant decline in market interest rates well below zero, followed by a rise in rates above zero only at the end of 2014. Given the zero lower bound on interest rates, this pointed to a significant need to ease monetary policy using other instruments. According to analyses, there was a danger of a sharp appreciation of the koruna, sustained deflation and a markedly slower economic recovery if this easing of the monetary conditions were not to occur. Conversely, an alternative scenario involving the use of the exchange rate of the koruna confirmed that a sustained weakening of the exchange rate to CZK 27/EUR was an effective instrument for averting the risk of deflation and accelerating the return of inflation towards the target while simultaneously delivering a stronger recovery in economic activity next year.

In the discussion that followed the presentation of the new forecast, a majority of the board members agreed that anti-inflationary factors had accumulated significantly since the previous situation report and that no upside risks to inflation were apparent over the entire forecast horizon. The Board also agreed that the appropriate response was to leave rates unchanged and to maintain them at technical zero over a longer horizon until inflation pressures increase significantly. The prevailing opinion was that the baseline scenario of the forecast, which was conditional on a substantial reduction of interest rates into negative figures, did not provide a realistic description of future developments. It was said several times that the alternative scenario, which assumed an easing of the monetary conditions by means of the exchange rate, provided a significantly better basis for monetary policy decision-making.

The Board discussed in detail the inflation forecast and the related alternative scenario proposal to ease the monetary conditions by means of foreign exchange interventions. The opinion was expressed that the need to ease the monetary conditions had been apparent since the start of this year and that the current evolution of inflation confirmed this need. It was said that the option of easing the monetary conditions by means of the exchange rate had been communicated for a long time now and that the use of the exchange rate was necessary to avert the risk of deflation and to return inflation towards the target. It was said that the central bank had an unlimited ability to weaken its own currency. It was also said that if the monetary conditions were not eased, the decline in prices would continue, the exchange rate would appreciate and the risk of sustained deflation would be entirely realistic. The opinion was expressed that it was necessary to react preventively and not wait until deflation occurred, and thus prevent losses in GDP and employment. It was also said that in the past the response to impending deflation had always been to ease monetary policy and that there had always been a credible monetary policy instrument available for any further steps in the future. However, the opinion was also expressed that the decline of inflation into negative territory was being driven primarily by a one-off change in administered prices of energy, and that the fall in administered prices would have a positive effect on the purchasing power of households in particular. It was also said that inflation expectations were still decently anchored, that monetary developments were not signalling any deflation risks, and that there were countries in Europe with lower inflation and higher rates. In response to this, it was said that adjusted inflation excluding fuels had been negative for several years now because of a long-standing negative output gap, and that inflation expectations were currently at historical lows. It was said several times in the discussion that the return of inflation to the target as implied by the model was itself currently subject to exceptional uncertainty and was, moreover, conditional on a further easing of monetary policy.

The Board also discussed the conditions of use of the exchange rate as a monetary policy instrument. It was said that the target level for the exchange rate could not be subject to frequent modifications. The opinion was expressed that the alternative scenario for the use of the exchange rate could imply additional uncertainties, such as a rise in exchange rate volatility after the interventions had been discontinued. In response to this, it was said that the use of the exchange rate could be discontinued only when it was very highly likely that there would be no need to return to it, and that it could be discontinued in such a way as to ensure that increased exchange rate volatility would not occur. It was emphasised that it was still appropriate for the Czech economy to have an inflation-targeting regime and that the exchange rate was an instrument falling within that regime, not outside it.

There was a consensus that there were unmistakable signs of an economic recovery, but also that this recovery was being driven by exports and would therefore not be a source of inflationary pressures. It was said that growth in industrial orders was apparent and that retail sales were indicating a recovery in consumer demand. It was also said that the current growth in nominal wages was very subdued and that this, coupled with increased consumption, might explain the fall in the saving rate. It was mentioned that despite the signs of recovery, the unemployment rate should increase further owing to structural factors and not start coming down until 2015. In the debate on domestic economic activity, the Board discussed gross capital formation, which was currently the main factor underlying the decline in GDP. It was said that inventories were currently very low and the forecast expected them to be gradually replenished. It was also said that the increased export performance was not yet having a palpable effect on investment and job creation.

The Board went on to discuss the possible impact of the alternative scenario involving the use of the exchange rate on the real economy. It was said that the cumulative impact of easing the monetary conditions by means of the exchange rate was unambiguously positive. However, the opinion was also expressed that the rise in inflation resulting from the interventions could have a negative impact on real wages. It was said that the possibility of substitution between foreign and domestic goods was limited and that the rise in import prices would lead to a fall in the purchasing power of households. It was said that uncertainty was a major factor underlying the currently subdued investment and that exchange rate interventions could increase that uncertainty. In response to this, it was noted that an increase in inflation would lead to a decrease in the expected real interest rate and to the maintenance of the long-running easy monetary conditions, thus fostering a shift in the growth of the economy towards its potential.

At the close of the meeting the Board decided unanimously to leave the two-week repo rate unchanged at 0.05%. Miroslav Singer, Mojmír Hampl, Vladimír Tomšík, Kamil Janáček, Lubomír Lízal, Pavel Řežábek and Eva Zamrazilová voted in favour of this decision. The Board also decided to start using the exchange rate as an additional instrument for easing the monetary conditions. The CNB will intervene in the foreign exchange market to weaken the koruna so as to keep the exchange rate of the koruna against the euro close to CZK 27/EUR.

Author of the minutes: Bořek Vašíček, Adviser to the Board