TEXT-Minutes from Czech c.bank Jan 25 board meeting

...on 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), Vladimir Tomsik (Chief Executive Director).

The Board discussed the January situation report containing the new forecast for inflation and other macroeconomic indicators. According the new forecast a modest slowdown in economic growth and persisting low monetary policy inflation (i.e. consumer price inflation adjusted for the first-round effects of indirect taxes) could be expected. The forecast for monetary policy inflation was gradually approaching 3 percent from below at the monetary policy horizon. By contrast, headline consumer price inflation should be above the 3 percent level at this time, as changes to indirect taxes were expected to have a significant effect. Compared to the previous macroeconomic forecast from October last year, expected inflation and forecast-consistent interest rates had been revised downwards. This was a result of the lower-than-expected inflation in 2006 Q4, the appreciation of the koruna exchange rate at the year-end and a smaller expected increase in indirect taxes in 2007. Economic growth was forecasted at approximately 5.3 percent in 2007 and 4.8 percent in 2008.

An extended core model - newly containing an equation modelling the labour market - had been used in the preparation of the forecast. The overall inflation pressures from the real economy were thus now described in a more structured way by means of the real marginal cost gap, consisting of the real wage gap and a redefined output gap. The overall effect of the real economy was currently estimated as slightly inflationary, with the output gap having an inflationary effect and the real wage gap a slightly anti-inflationary effect. Compared to the October forecast, the estimate of future inflation pressures from the real economy was consequently lower. Expected external economic growth had risen, but on the other hand energy prices had fallen and lower external inflation could be expected as a result.

Consistent with the new macroeconomic forecast and its assumptions was a period of interest rate stability and then a gradual rise in interest rates.

After the presentation of the situation report, the Board discussed the risks and uncertainties associated with the new forecast. The Board agreed that there were risks on both the upside and downside. The future evolution of the exchange rate was viewed as a two-sided risk. At the time of the meeting, the koruna's rate against the euro was weaker than assumed in the forecast, and this posed an upside risk to inflation. At the same time there was a consensus that a further correction of the earlier rapid appreciation could not be ruled out either. This might occur as a result of the negative interest rate differential, which could, moreover, widen further. That said, according to market expectations the koruna should be stronger in the future than according to the CNB forecast, and this posed a downside risk to inflation. It was stated in the discussion that this was consistent with the persisting attractiveness of the Czech economy and the still sufficient room for foreign direct investment inflow. The argument was also made that the appreciation of the Czech currency against the euro was linked with developments in the region and that the decision-making of large financial investors was not based solely on the interest rate differential.

There was a consensus that the upside risks to inflation also included the robust economic growth in neighbouring countries, as the latest indicators from these countries were even better than originally assumed in the forecast. Conversely, the opinion was expressed that oil prices were a medium-term downside risk owing to the observed fall in aggregate demand for this commodity, the opening of new oil fields and the shrinking role of oil as an alternative investment asset. Against this, however, it was said that a deviation in prices of oil and oil products would have to be big to be economically significant. The discussion of the risks then turned to the determinants of food prices going forward. Strong and persisting competition on the Czech food market, the opening of the European market and continuing cost optimisation in primary agricultural production were given as reasons why food represents a downside risk for the forecast. Against this, however, the argument was made that the gradual transition of foods from non-tradable to tradable commodities might have the opposite effect, because the price level on the Czech market was lower than in other relevant countries.

The Board also focused on fiscal policy developments. Here it saw risks on both sides in relation to the forecast. If the new government succeeded in its plans to cut the budget deficit, this might foster lower-than-forecasted inflation. Conversely, the proposed tax changes, in particular the potential raising of the lower VAT rate, might have inflationary effects.

The discussion also covered the trends and equilibrium variables on which the forecast was based. The opinion was expressed that large industrial investments - for example the new car plant in Kolin - imply a transitory increase in growth in the potential, non-accelerating inflation level of output. That in turn poses a downside risk to inflation. By contrast, regarding the trends on the labour market the opinion was expressed that wage growth may represent a medium-term upside risk, as the fairly subdued wage growth to date was extrapolated in the forecast. It was said that although wages in the lowest-paid jobs might have been depressed by the inflow of cheap labour, this factor may now be reaching its limits. Mention was also made of the more general question of whether the current faster growth in profits than wages was sustainable and whether the opposite phenomenon might be seen in the future.

There was also a more general discussion of the rapid rise in asset prices amid low consumer price inflation. The board members discussed whether or not monetary policy should respond to asset price movements. The opinion was expressed that it should not, as the asset price growth may be just a consequence of rapidly rising wealth coupled with limited investment opportunities. From this point of view it was possible to view the asset price movements as equilibrium ones. It was also said that if monetary policy did respond to the rising asset prices, consumer prices would probably fall. There was also a related discussion of the negative effect of the deflation which was maybe occurring as a result of the statistical overvaluation of inflation. However, it was also said in this discussion that prices of tradable commodities had been falling for some time without this causing any major problems to the relevant sector.

In light of the numerous risks, the Board agreed that there was greater uncertainty regarding future interest rates consistent with the fulfilment of the inflation target. Opinions were also expressed that a future rate cut could not be ruled out, depending on how the situation develops.

After discussing the situation report, the Board decided unanimously to leave the two-week repo rate unchanged at 2.50 percent.

(Reporting by Mirka Krufova in Prague) ((prague.newsroom@reuters.com; Reuters Messaging: mirka.krufova.reuters.com@reuters.net; +420 224 190 477))

Keywords: CZECH ECONOMY/CBANK

[Reuters/Finance.cz]