The Setting of the Inflation Target for 2002-2005

The first phase of inflation targeting, demarcated by the year 1998 and the medium-term inflation target for 2000, saw a significant decline in the annual price indices and a slowdown in inflation to a substantially lower level. Despite intense price pressures generated in 2000 by an external cost shock and uncertainties about its secondary effects, both inflation and inflation expectations were maintained at a low level. The stabilised macroeconomic and price environment created favourable conditions for continuing economic recovery and sustainable economic growth in the subsequent period.

The medium-term intention of reinforcing the macroeconomic stability achieved and maintaining low inflation was reflected in the form and level of the inflation target announced in April 2001. The Czech National Bank, by agreement with the Government, announced an inflation target for annual consumer price index growth in January 2002-December 2005. The inflation target takes the form of a continuous band descending evenly from 3%-5% in January 2002 to 2%-4% in December 2005 (see the chart below).



As stated in Government Resolution No. 325/01 of 9 April 2001, "the quantification of the inflation target assumes smooth completion of the deregulation of administered prices, whose effect on headline inflation should be between 1.0 and 1.5 percentage points in the stated period. However, it does not take into account potential step changes in indirect taxes. Should the actual changes in regulated prices and administrative measures diverge from these assumptions, the CNB - when targeting headline inflation - will apply the institute of escape clauses so that inflation returns to the original targeted trajectory without excessive macroeconomic costs".

Targeting headline inflation, i.e. growth in the consumer price index, means targeting a wider and therefore more representative price index than is the case with net inflation, and one which is well understood by the public. This increases the inflation target's potential for influencing inflation expectations.

The target band should help to stabilise inflation and inflation expectations at a low level and facilitate the transition to the long-term inflation target. This band can also be expected to leave enough leeway for price adjustment connected with convergence towards the European Union. The setting of a longer-term target trajectory conforms to the medium-term nature of monetary policy and to the practice of the majority of inflation-targeting central banks. An inflation target in the form of a continuous band should enhance the comprehensibility and transparency of monetary policy decision-making and make it easier for both the CNB and the public to assess whether monetary policy instruments are set correctly.