Minutes of the Bank Board Meeting on 7 May 2014

Present at the meeting: Miroslav Singer, Vladimír Tomšík, Kamil Janáček, Lubomír Lízal, Jiří Rusnok, Pavel Řežábek.

The meeting opened with a presentation of the third situation report and the new macroeconomic forecast covering the horizon up to the end of 2015. The Czech economy had expanded by 1.2% year on year in 2013 Q4 after almost two years of contraction, with all demand components except inventories having contributed to the growth. In quarter-on-quarter terms, economic activity had risen for the third consecutive quarter. As expected, headline inflation had dropped sharply to 0.2% on average in 2014 Q1 (monetary-policy relevant inflation had fallen to 0.1%), and was thus well below the lower boundary of the tolerance band around the CNB’s target. Without the weakening of the koruna exchange rate, inflation would have been deep in negative territory at the start of this year.

The new forecast was based on an assumption of stable market interest rates at their current very low level and a flat exchange rate of the koruna close to CZK 27 to the euro until the start of next year. The subsequent return to conventional monetary policy would not imply appreciation of the exchange rate over the forecast horizon to the level recorded before the intervention regime started. The forecast expected headline inflation to increase this year from its current very low but positive level. The weakened koruna would continue to affect inflation through import prices. Starting in the second half of this year, consumer price inflation would also be strongly affected by continuing growth of the domestic economy and a recovery in wages. Headline inflation would thus get slightly above the target at the start of next year and return towards the 2% target in the second half of 2015. Average inflation would be 0.8% this year and increase to 2.2% next year. Monetary-policy relevant inflation would return towards the target at the end of this year and stay very close to the target next year. Following a decline in the previous two years, the economy would grow by 2.6% this year. Economic growth would be fostered by accelerating external demand, the easing of the domestic monetary conditions via the exchange rate of the koruna and, to a lesser extent, also fiscal policy. Economic growth would pick up further to 3.3% in 2015.

In the discussion that followed the presentation of the new forecast, the prevailing opinion was that the risks to the new forecast were slightly anti-inflationary. There was a consensus that the appropriate response was to leave rates unchanged. The Board also agreed that the exchange rate commitment of CZK 27 to the euro could still be considered appropriate and that the exchange rate could be expected to be kept close to that level at least until the start of 2015. A majority of the board members agreed that, in light of the decrease in the inflation outlook, the probability of a later exit from the exchange rate commitment was increasing. It was also said that the uncertainties were growing, but the observed deviations from the previous forecast were too small to warrant considering any change to the current monetary policy parameters. It was said that the exit from the regime of using the exchange rate should be conditional on certain conditions being met, and that those conditions were more important than the actual timing of the exit from the intervention regime. In this context, it was said repeatedly that the exit had to be conditional primarily on the certainty that inflation would be kept close to the inflation target. It was said that the exit could be phased in such a way as to ensure that interest rates would not have to be increased at the same time as the exchange rate commitment was ended. The exit scenario had envisaged inflation returning to the target from above, and inflation moving in the upper half of the tolerance band should not be a cause for concern. In this regard, it was said that domestic interest rates should not rise as fast as forecasted in 2015 and that this itself could foster desirable inflationary pressures.

The Board discussed in detail the forecast for domestic inflation and its domestic and external factors. It was said that the baseline forecast scenario was relatively optimistic and subject to anti-inflationary risks. The opinion was expressed that economic developments were diverging from price developments and the observed economic recovery was not being accompanied by major growth in inflationary pressures. It was said that import prices were the sole rising component of inflation and that domestic inflationary pressures would not re-emerge until the monetary policy horizon. It was also said that administered prices were the only major anti-inflationary surprise. In this regard, it was said that administered prices were linked with energy prices, which, due to non-market interventions, were following a different path than the economy, and might therefore continue falling. It was also said that the energy market had been hit by the slump in demand and that the energy market in Europe was experiencing no major technological progress, a fact reflected, among other things, in producers’ financial results. It was said several times that foreign price developments represented a significant downside risk to inflation. It was said that the euro area was experiencing disinflation, visible also in producer prices, and that this was contributing to the ECB maintaining easy monetary policy. The opinion was expressed that continued deleveraging in the euro area would hinder demand and that this represented a downside risk to inflation. However, the opinion was also expressed that food and energy prices might deliver an upside surprise in the course of the year. It was said that although no major fiscal expansion could be expected, growth in transfer payments might also be an upside factor next year.

The Board also discussed the degree of exchange rate pass-through to prices and wages. It was said that it was still uncertain whether the weakened exchange rate would provide a sufficient inflationary stimulus in a situation of relatively subdued inflation abroad. It was said repeatedly that the overall effect of the pass-through of the weakened exchange rate to the economy was not yet complete and therefore could not be assessed yet. The opinion was expressed that the assumption that the exchange rate pass-through to prices is higher at the zero lower bound on interest rates might not hold, and that the inflation forecast was strongly conditional on the assumption that the exchange rate pass-through would have second-round effects via the real economy and wages. The opinion was also expressed that the magnitude of the expected pass-through to import prices had been confirmed and that there was no reason to doubt the magnitude of the second-round effects. It was also said that the overall wage growth forecast was over-optimistic given the latest wage developments and the likely heterogeneity of the economic recovery across sectors. In this regard, it was said that the domestic economy had been capable of generating wage pressures in the past. It was said that the wage growth forecast for next year would not be confirmed until the results of wage bargaining became known in the autumn.

In the context of the long period of low interest rates, the value of the equilibrium real interest rate for the Czech economy was also discussed. It was said that although the economy was gradually approaching its steady state, implied real rates would be negative, which was incommensurate with their equilibrium level. In this regard, it was said that the domestic interest rate outlook was significantly influenced by the low interest rate outlook in the euro area. The opinion was expressed that domestic real rates would gradually attain positive values as the convergence process was renewed.

Economic activity was then discussed. There was a consensus that the domestic economy was experiencing a recovery along with the euro area. It was said that, according to the current forecast, domestic GDP growth should be higher than that in the euro area. It was said that the domestic output gap had probably been more negative than assumed, as evidenced by a fall in wages and disposable property and investment income at the end of last year. The opinion was expressed that a more negative output gap also explained the fact that the economic recovery resulting from the monetary easing was stronger. In a discussion of the components of GDP, the Board focused on fixed investment and inventories. It was said that the intensity of growth in fixed investment at the end of last year was surprising and might indicate an economic recovery. It was said that the sharp decline in inventories that had occurred despite the cigarette frontloading effect was equally surprising. In this regard, it was said that the volatility of inventories over time was the cause of unintuitive jumps in the GDP forecast. It was said that the leading indicators were positive, but some external factors might have a negative effect on the recovery. The opinion was expressed that the positive signals were not yet strong enough to warrant any reaction to them, not least because of the persisting negative output gap. It was also said that the importance of net exports as an economic growth factor should gradually decrease in favour of consumption and investment. The opinion was expressed that developments in the retail sector, especially the motor vehicle segment, indicated that speculative deferral of consumption had been going on. In this regard, it was said that the partial improvement in the labour market was starting to manifest itself in durable goods markets as well.

At the close of the meeting the Board decided unanimously to leave the two-week repo rate unchanged at 0.05%. Miroslav Singer, Vladimír Tomšík, Kamil Janáček, Lubomír Lízal, Jiří Rusnok and Pavel Řežábek voted in favour of this decision. The Board also decided to continue using the exchange rate as an additional instrument for easing the monetary conditions and confirmed the CNB’s commitment to intervene in the foreign exchange market if needed to weaken the exchange rate so as to keep the exchange rate of the koruna close to CZK 27 to the euro.

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