Minutes of the Bank Board Meeting on 5 May 2022

Present at the meeting: Jiří Rusnok, Marek Mora, Tomáš Nidetzký, Vojtěch Benda, Oldřich Dědek, Tomáš Holub, Aleš Michl.

The meeting opened with a presentation of the third situation report and the new macroeconomic forecast. According to the forecast, inflation would rise to 15% in the months ahead and remain in double figures for the rest of this year. This would reflect continued growth in gas and electricity prices for households, a further acceleration in food price inflation and persisting high core inflation. Inflation would decline below 10% in early 2023 owing to an easing of the current exceptional price pressures and to the previous tightening of domestic monetary conditions. This would foster a further rapid decrease in inflation, which would fall close to the 2% target in the second half of 2023. Consistent with the baseline scenario of the forecast was a further sharp rise in market interest rates until the middle of this year, followed by a gradual decline from autumn 2022.

The Board assessed the uncertainties and risks of the baseline scenario of the spring forecast as being significant and going in both directions. Given the nature of the currently predominant cost-push inflation factors, which are feeding through to inflation gradually and with a lag, a majority of the Board viewed a scenario featuring a more distant monetary policy horizon as a legitimate guide for the current interest rate decision. A majority of the Board regarded the risks of this scenario as inflationary, mainly because of the threat of inflation expectations becoming unanchored. Consistent with this was an interest rate increase of 0.75 percentage point.

In this context, the impacts of the war in Ukraine were discussed. Tomáš Holub noted that the war was exacerbating the stagflation dilemma of monetary policy. Marek Mora and Vojtěch Benda pointed out that the new forecast contained a dramatic increase in the inflation outlook for this year, amid a significantly larger economic downturn. According to Jiří Rusnok, the shortages and high prices of inputs were hitting the Czech economy much harder than Western European countries. This was due to the structure of the highly industry and foreign trade-oriented Czech economy. He also mentioned the strong trade and ownership interconnectedness of the Czech Republic as a supplier to the German economy, which was heavily involved in the Ukrainian and Russian markets. In the discussion that followed, the Board repeatedly also mentioned the risk of a halt in supplies of Russian oil and natural gas to Europe. According to Jiří Rusnok, this would have very dramatic consequences for European economies. In his opinion, the adjustment of the Czech economy to such a de facto war situation would also require modifications to be made to the current model mechanisms, which were not adapted to this type of shock. According to Tomáš Holub, however, this scenario, too, would have stagflationary consequences. Jiří Rusnok and Marek Mora then also drew attention to the continuing anti-epidemic lockdowns and related economic slowdown in China. Repeated mention was also made of the uncertainty regarding the impacts of the faster tightening by the Fed, which would increase debt service costs, especially in developing and emerging economies, which were more heavily indebted now than in the past (Marek Mora and Vojtěch Benda).

The board members agreed that the structure of the inflation pressures had shifted significantly from domestic demand factors to external supply and cost factors due to the war. Jiří Rusnok, Vojtěch Benda and Tomáš Holub pointed out that the domestic demand-pull inflation factors remained quite strong and would not subside quickly by themselves, in the same way as the external cost pressures. Vojtěch Benda felt that the positive gap in profit mark-ups reflected strong domestic demand-pull price factors, causing him to favour a more forceful monetary policy decision. Against this, Tomáš Nidetzký noted that the growth in energy prices, the impacts of the war in Ukraine and the previous tightening of domestic monetary policy, coupled with the sharp deterioration in sentiment, would slow demand sufficiently. Besides rapidly decreasing corporate investment this year, he also drew attention to the observed downswing in firms’ gross operating surplus, which he regarded as a more important indicator of the condition of the corporate sector than profit mark-ups. In this context, Marek Mora and Oldřich Dědek noted that the sharp rise in interest rates in the first half of this year assumed in the baseline scenario of the forecast did not take account of the source of these price factors. Oldřich Dědek remained sceptical that a sharp increase in interest rates could contain the inflation pressures, which, conversely, were continuing to accelerate, as they were being driven exclusively by external cost factors. He pointed to Slovakia, which was tied to the very accommodative monetary policy of the ECB, while the current inflation rate in Slovakia was two percentage points lower than that in the Czech Republic. In this regard, therefore, he would not overestimate the ability of CNB monetary policy to combat the predominantly cost-push inflation with interest rates. On the contrary, he was of the opinion that the aggressive monetary policy was contributing to the unanchoring of inflation expectations, as inflation was accelerating despite the sharp increases in interest rates. Against this, Jiří Rusnok pointed out that the higher domestic inflation by comparison with the European average could be explained quite easily by the specifics of the Czech economy. As examples, he gave the long-term extremely tight labour market, the very relaxed fiscal policy and the overheated property market, which reflected insufficient construction as well as easy monetary policy. He therefore regarded the idea that there was no need to raise interest rates in the present situation as an abdication of the central bank’s price stability mandate. In response to the comment that inflation was continuing to rise despite the relatively sharp interest rate increases, he noted that less than a year had passed since the start of the tightening cycle. In a discussion about monetary policy flexibility under inflation targeting, a majority of the board members agreed with the message of a scenario featuring a two quarters more distant monetary policy horizon, which would imply a need for a smaller tightening at today’s monetary policy meeting by comparison with the baseline scenario. In this connection, Tomáš Holub noted that the current length of the monetary policy horizon was optimal for standard situations. However, together with Vojtěch Benda and Tomáš Nidetzký, he pointed out that it was currently not the case that the first-round impacts of the observed price shocks would fade away in four quarters as usual. In the case of energy prices in particular, a shock on commodity exchanges takes up to half a year to pass through to consumer prices and subsequently remains in annual inflation for another four quarters.

The Board’s following discussion also covered the risk of inflation expectations becoming unanchored. The majority view was that the high inflation was not yet spilling over into a significant surge in nominal wage growth. Marek Mora put this down in part to the high credibility of the CNB’s monetary policy, which was a result among other things of the previous sharp interest rate increases. Nonetheless, there was simultaneously also a prevailing view that the inflation expectations of households and firms were now showing some signs of becoming unanchored and that this was also being reflected in inflation. For this reason, Tomáš Holub did not see it as meaningful in this situation to continue to try to separate inflation strictly into demand and supply components, as this breakdown only makes sense when inflation is determined exclusively by these two factors in a situation of firmly anchored inflation expectations which are not themselves contributing to inflation in any way. A majority of the Board then agreed that it was also impossible not to respond to the clear cost shocks passing through significantly to domestic inflation due to strong demand, which needed to be cooled with tighter monetary policy. In this regard, Marek Mora noted that the best contribution the CNB could make to the economic prosperity of the Czech Republic would be to achieve low and stable inflation as soon as possible. He and Tomáš Holub said it was desirable to continue raising interest rates to ensure price stability, even at the cost of an economic downswing. In the present situation, it was important to realise and communicate that the objective of the CNB’s forceful response was not to damage the economy but to protect it from a far worse outcome. This would occur if it became necessary to reduce inflation after it became embedded in the economy and expectations. Against this, Oldřich Dědek repeated that he viewed combating the exclusively external cost-push price pressures by radically increasing interest rates as economically costly, counterproductive, and ineffective as regards the impacts on inflation. According to Aleš Michl, two anti-inflationary measures were now necessary – a gradual reduction of the state budget deficit and the prevention of indexation of wages to inflation.

In a discussion of the monetary stance, the Board agreed that in a situation of such exceptional uncertainties, associated primarily with the impacts of the war in Ukraine, it was necessary to be extremely cautious when making monetary policy decisions, as it was not clear how big the risks might grow. Aleš Michl and Oldřich Dědek repeated that the outbreak of war in Ukraine represented a structural break that was making the policy of sharp rate hikes even more problematic. The cost-push nature of the present inflation, now exacerbated by the war, would continue to make it impossible to rein in inflation using interest rates. In their opinion, it would be more appropriate to leave interest rates unchanged for a few months and continue to assess the situation. Conversely, the trend of relatively rapid monetary policy tightening around the world, and especially by the US Fed, was repeatedly mentioned as one of the risks going beyond the assumptions of the interest rate forecast. In this context, a majority of the Board did not regard the baseline scenario of the forecast, which assumed a rapid decline in domestic interest rates in the second half of this year, as very likely. Vojtěch Benda said that domestic interest rates would be higher for longer.

Regarding the exchange rate, there was a consensus that, given the source of most of the currently observed inflation pressures, the need for a tighter exchange rate component of the monetary conditions was greater than usual. Vojtěch Benda identified the exchange rate as a key factor which, via import prices, was partially dampening the pass-through of the high foreign prices to domestic inflation. He also said that the long stable exchange rate of the koruna at relatively strong levels was also due in large measure to the significantly positive interest rate differential. A majority of the board members said that it was therefore necessary to tighten monetary policy further, all the more so now given the upward trend in interest rates around the world. In this overall context, Jiří Rusnok, Marek Mora, Vojtěch Benda and Tomáš Holub therefore conceded it was possible to consider raising interest rates by 100 basis points. Against this, Oldřich Dědek said that the koruna had not strengthened significantly against the euro since last October, which, given the sharp growth in the interest rate differential over the same period, demonstrated the predominance of global effects on the exchange rate. Instead of a further interest rate hike, he therefore preferred the option of selling off international reserves, which would partially contain any depreciation pressure on the exchange rate. Jiří Rusnok also pointed to the risk of a weaker exchange rate connected with the growing global risks, since the koruna – as the currency of a small open economy with a floating exchange rate – was very sensitive to these external shocks. A majority of the other board members also voted in favour of increasing the sale of international reserves. They identified restricting growth in the CNB’s balance sheet as the primary objective of this measure and currently viewed its effect on the exchange rate of the koruna as a potential favourable side effect. Nonetheless, Tomáš Holub did not expect this step to have a large impact on the exchange rate.

The Board also discussed the fiscal assumptions of the forecast. Tomáš Holub viewed the additional expenditure on assistance for refugees and especially on compensation for the rising cost of living for Czech households as a clear signal that no significant tightening of fiscal policy could be expected. In this regard, Vojtěch Benda pointed out that countries that had borrowed significantly during the coronavirus pandemic and had not subsequently reduced their debt or had since borrowed even more (the Czech Republic, Slovakia and Romania) were experiencing distinctly higher inflation than countries that had cut their debt levels significantly (Greece, Cyprus, Portugal and Malta). He also said that as fiscal policy remained relatively relaxed in the Czech Republic, it was reasonable to assume stronger and longer-lasting inflation pressures and a need for more aggressive monetary policy than, for example, in Poland and Hungary, where some fiscal consolidation had taken place.

Part of the Board’s debate was focused on financial stability. Vojtěch Benda and Tomáš Holub noted that neither the current interest rate level, nor a further hike in line with the forecast posed a risk to financial stability. On the other hand, Tomáš Holub conceded that the period of monetary policy actions contributing simultaneously to the achievement of the financial stability objective was now probably coming slowly to an end. However, the CNB could not abandon its primary mandate of price stability, which, in a situation where inflation was heading towards 15%, had priority over all else. Against this, Oldřich Dědek said that the higher inflation was due in part to aggressive monetary policy, depending on firms’ ability to pass on their rising interest expenses to their customers in the form of higher prices. Marek Mora and Tomáš Holub disagreed with the view that the rising interest rates were significantly burdening the business sector via increased debt service costs. Tomáš Holub also pointed out that it was important not to neglect households, which, due to the current inflation, had lost CZK 250–300 billion in real terms as measured by the purchasing power of their savings, so it was necessary to prevent this trend from continuing any further by means of tighter monetary policy.

At the close of the meeting the Board decided to increase the two-week repo rate by 75 basis points to 5.75%. At the same time, it increased the discount rate by the same amount to 4.75% and the Lombard rate to 6.75%. Five members voted in favour of this decision: Jiří Rusnok, Marek Mora, Tomáš Nidetzký, Vojtěch Benda and Tomáš Holub. Two members, Oldřich Dědek and Aleš Michl, voted for leaving interest rates unchanged.

Author of the minutes: Martin Motl, Monetary Department