Minutes of the Bank Board Meeting on 31 July 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 fifth situation report and the new macroeconomic forecast covering the horizon up to the end of 2016. Domestic economic growth had accelerated to 2.9% year on year in 2014 Q1, with all demand components except inventories having contributed. In quarter-on-quarter terms, economic activity had risen for the fourth consecutive quarter. Headline inflation had been at low but non-negative levels since the start of this year, averaging 0.2% year on year in 2014 Q2. The price level adjusted for the effects of changes to indirect taxes had been unchanged year on year in 2014 Q2. Inflation was thus still well below the lower boundary of the tolerance band around the CNB’s target. The weakened exchange rate had so far been feeding through to inflation mainly via higher import prices, but it had also contributed to faster growth in the domestic economy and to a positive change in the labour market.

The new forecast was based on an assumption of flat market interest rates at their current very low level and the use of the exchange rate as a monetary policy instrument until 2015 Q3. The subsequent return to conventional monetary policy would not imply appreciation of the exchange rate to the level recorded before the intervention regime started. The forecast expected headline inflation to increase gradually from its current very low levels and to return to the 2% target in the second half of 2015. It would then stay close to the target in 2016. The inflationary effect of import prices would fade this year owing to subdued inflation abroad amid a stable exchange rate of the koruna. In the second half of this year, by contrast, the domestic economy would start to contribute to inflation, chiefly as a result of accelerating wage growth. Average inflation would be 0.4% this year and increase to 1.8% next year. Monetary-policy relevant inflation would follow a similar path to headline inflation, but at a slightly lower level. Following a decline in the previous two years, the Czech economy would grow by almost 3% this year. Economic growth would be fostered by accelerating external demand, the easing of the domestic monetary conditions via the weakened exchange rate and exceptionally low interest rates, and higher government investment. In the following two years, the economy would record similar growth rates as this year.

In the discussion that followed the presentation of the new forecast, a majority of the board members agreed that the risks to the new forecast were slightly anti-inflationary. It was said that following the introduction of the intervention regime, economic agents had reacted as predicted to the price signal expressed in terms of import price inflation. This was indicated, for example, by the retail sales figures. It was noted several times that the first-round effect of the weakening of the koruna on inflation via import price growth was still ongoing. In this context, it was said that the second-round effects, comprising an economic recovery and wage growth, were now starting to play the main role and that the observed contribution of the interventions to the recovery was plain to see. However, the opinion was also expressed that the second-round effects of the exchange rate weakening were associated with greater uncertainty than the first-round effects. There was a consensus that the appropriate response was to leave rates unchanged at technical zero and to maintain the exchange rate close to CZK 27 to the euro.

A majority of the board members agreed that in light of the slightly anti-inflationary risks to the forecast, the assumed parameters of the exchange rate commitment did not deliver a monetary easing of the necessary magnitude and that the use of the exchange rate as an additional monetary policy instrument would thus continue at least until 2016 and that the slightly anti-inflationary risks to the forecast did not justify moving the intervention level in the weaker direction. In this context, it was said repeatedly that the exchange rate represented a relatively crude monetary policy instrument, one which by nature could not be used for finer smoothing of monetary policy. It was also said several times that the situation in November last year, when this instrument had first been used, had been completely different, especially as regards the movement of inflation expectations, economic growth, the velocity of money, the change in the saving rate and the composition of inflation pressures.

The Board discussed the domestic inflation forecast and the domestic and external inflation factors in detail. A majority of the board members agreed that with regard to the sources of inflation pressures, there would very likely be a switch in the near future from inflationary import prices to an inflationary domestic economy. Growth in adjusted inflation excluding fuels, which had recorded positive values for the first time in almost five years, was mentioned several times as a signal of this change. It was said that given the growing role of changes in market prices, inflation had bottomed out in 2014 Q2.

It was said repeatedly that highly subdued external inflation was the main fundamental factor pushing inflation downwards. It was said several times that inflation in the euro area was significantly below expectations, the price index outlooks were being revised downwards and there was no sign of any change that might have a further negative effect on domestic inflation in the future. In this context, the board members discussed the possible impacts of the ECB’s actions to ease monetary policy planned for September. It was said that regardless of the effectiveness of these measures, their impact on inflation in the euro area would be lagged and not immediately observable. It was said that the impact of the ECB’s measures was itself associated with uncertainty. However, a majority of the board members agreed that inflation in the euro area represented a slightly anti-inflationary risk to the inflation forecast.

Another repeatedly mentioned factor reducing current inflation was food prices, which, given the good harvest, might push inflation down in the near future as well. It was said that the current decline in food prices was temporary. In this regard, it was said that food prices do not play a major role in monetary policy considerations owing to their volatility and their dependence on circumstances beyond the control of monetary policy (for example the weather). It was also said that another possible factor pushing the food price outlook downwards was growth in the supply of food resulting from potential restrictions on food exports to Russia.

The Board also discussed domestic economic growth and its impacts on inflation. There was a consensus that the observed recovery in domestic economic activity was robust and gaining pace. In this context, it was noted that the accelerating recovery was visible even in a situation where the Czech Republic’s largest trading partners were not experiencing accelerating economic growth. It was also said that the economic recovery had initially been driven by external demand, which would probably gradually spill over into all components of domestic demand. One of these components was household consumption, which was an important factor in the further growth of the domestic economy expected by the forecast. It was noted that the currently observed growth in household consumption was being driven largely by insurance premiums and that this cast some doubt on the robustness of the recovery in consumption. However, it was also said that the household consumption data provided by the household budget survey might not be representative. It was also said that according to the forecast the rising saving rate would not exceed the rate observed just before the interventions started and that this pointed to significant postponement of consumption in the second half of 2013, indicating the deflationary nature of the economy. In a discussion of the impacts of economic growth on inflation, it was said that the output gap was still negative, consistent with the non-inflationary nature of the recovery so far, but was closing. However, it was also said that the observed growth in investment would lead to growth in potential output, which, via slower closure of the output gap, might conversely lead to future suppression of the inflation pressures stemming from the domestic economy

In a discussion of the situation abroad, the Board agreed that this situation implied increased uncertainty. This applied above all to the geopolitical situation in Ukraine and the impacts of the sanctions imposed on Russia. In this context, it was said that the impact of the sanctions could not yet be assessed with any great accuracy in the present situation. Other external uncertainties mentioned included the impact of regulation on the banking sector in Europe and the situation in Spain and Portugal.

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: Michal Franta, Adviser to the Board