TEXT-Minutes from Czech c.bank July 26 board meeting

...Friday.

Present at the meeting: Zdenek Tuma (Governor), Ludek Niedermayer (Vice-Governor), Miroslav Singer (Vice-Governor), Mojmir Hampl (Chief Executive Director), Robert Holman (Chief Executive Director), Pavel Rezabek (Chief Executive Director), Vladimir Tomsik (Chief Executive Director).

The meeting opened with a presentation of the new macroeconomic forecast. Newly acquired information on developments at home and abroad had moved the macroeconomic forecast upwards in all its components. The real economy would have an upside effect on inflation for the remainder of the year. The existence of a positive output gap and a further gradual widening of that gap this year, along with expectations regarding external economic developments and the effect of fiscal policy, had led to the economic growth forecast being increased above 6 percent for 2007. The growth was then expected to ease slightly to around 5.5 percent in 2008. In 2007, therefore, the economy would grow at a faster pace than the expected rate of growth of potential output. Domestic consumption would become the most significant component of economic growth this year, bolstered by a high rate of growth of real wages and social transfers. In 2008, the economic growth was expected to be driven by investment. Expectations of high real export growth would be offset by high real import growth. Net exports would thus contribute only minimally to real GDP growth.

The inflationary signals from the domestic and external economies had pushed the inflation forecast upwards compared to April. In the next few quarters the inflation forecast primarily reflected an increase in the forecast for import prices, whereas in the longer run the lagged effects of the real economy would emerge. Like this year, however, the future course of inflation would be significantly affected by the impacts of tax changes. The introduction of "environmental" taxes had also been newly incorporated into the forecast. The contribution from administrative effects would peak in the first quarter of 2008. In the second half of this year, inflation would thus accelerate in all its components, and at the monetary policy horizon, i.e. in the second half of 2008, it would lie above the upper boundary of the tolerance band for the inflation target. Monetary-policy relevant inflation in the same period would be in the upper half of the tolerance band, while showing a gradual return to the centre of the band.

Consistent with the macroeconomic forecast and its assumptions was growth in nominal interest rates.

The presentation of the new macroeconomic forecast was followed by a discussion of the risks and uncertainties associated with the forecast. In the discussion of the starting points of the forecast, it was said that the economy was going through a phase of dynamic economic growth, which, unlike in the past, was being accompanied by an economic upswing abroad. The outlook for foreign interest rates had also increased and this was adding to the depreciation pressures on the exchange rate. It was said that information from the labour market was confirming the forecast of strong domestic demand growth, and the observed growth of the money supply was also mentioned as an upside factor. On the other hand, however, the opinion was also expressed that the relatively buoyant economic growth had not yet fostered increased inflation pressures and it was not entirely certain that this situation would not continue to apply.

A majority of the board members concurred that there had been a comparatively sizeable upward revision of the forecast, including for the implied interest rate path. However, it was not possible to identify a single strong factor underlying this revision. It seemed, rather, that there were numerous minor inflationary effects involved. By contrast, the sole downside factor to have materialised was the koruna-dollar exchange rate. It was said, however, that the forecast had come as no surprise, given the observed economic developments. In this context, it was said that the April forecast, which was being fulfilled at its upper limit, had expected a rising interest rate path. As a counter-argument, however, it was said that if the April forecast was being met, there was no clear reason to revise the current forecast by comparison with April.

One of the items discussed was the downside effect of the stable inflation expectations in response to the tax changes. It was said that in an economy where inflation had long been close to the inflation target, inflation expectations were well anchored. The monetary policy response could thus be more gradual.

The expected exchange rate path was identified as a potential downside risk of the forecast. It was said that in a situation of expected closure of the interest rate differential, faster-than-forecasted appreciation of the koruna could not be ruled out. This risk could be augmented by any rise in interest rates beyond the framework expected by the financial market. Given that part of the upward revision of the forecast was due to an increase in import prices, an appreciation of the exchange rate would probably change the outlook for future inflation. It was said that some degree of caution was therefore appropriate in this situation. At the same time, however, it was also said that exchange rate fluctuations in either direction were natural in a small open economy and that a central bank targeting inflation and not the exchange rate should not be overly concerned by short-term exchange rate volatility.

In this context, the Board debated at some length the magnitude of any interest rate increase and its impact on the financial markets and also the impact of today's decision on the future monetary policy settings. In this discussion, the opinion was expressed that stronger monetary policy responses would be appropriate primarily in the event of economic shocks. It was also said that fulfilment of the current forecast was a required condition for a further tightening of monetary policy. However, a majority of the board members agreed on the need for another interest rate increase if the current forecast was met.

At the close of the meeting the Board decided by a majority vote to increase the CNB two-week repo rate by 0.25 percentage point to 3.0 percent, effective 27 July 2007. At the same time it decided to increase the discount rate and Lombard rate by the same amount, to 2.0 percent and 4.0 percent respectively. Six members voted in favour of this decision, and one member voted for increasing the rates by 0.5 percent. (Reporting by Mirka Krufova in Prague)

Keywords: CZECH ECONOMY/CBANK

[Reuters/Finance.cz]