Economic performance remained strong in 2007, supported by continued robust growth of domestic demand. The current account deficit widened, but remained largely financed by inflows of direct investment. With vulnerabilities limited, the economy weathered the international financial market turmoil with minimal spillover impact. The strong economy boosted job creation while unemployment declined and capacity utilization reached record high levels. In this environment, inflation pressures mounted on account of higher domestic demand amid tightening labor markets as well as food and regulated price increases. Monetary policy was tightened in the second half of the year, although policy rates remain among the lowest in the EU.
Inflation is expected to almost double to above 5 percent, owing to food, energy and indirect tax increases, as well as demand and wage pressures. Risks of higher inflation expectations feeding into wage and price-setting remain while a slower pace of koruna appreciation could also increase inflation pressures. Shaping expectations is thus critical, especially with the planned lowering of the inflation target to 2 percent by 2010.
Directors commended the authorities on their prudent monetary policy, and supported the recent policy tightening to counter rising inflation pressures. With inflation set to rise to well above the target of 3 percent, Directors stressed the importance of ensuring that expectations remain well anchored to the inflation target through further timely monetary policy action. The appropriate pace of monetary tightening will depend, inter alia, on the degree of koruna appreciation and second-round effects of indirect tax and energy and food price increases. The planned downward shift in the inflation target to 2 percent from 2010 underscores the importance of preserving the Czech National Bank's high credibility. In this context, Directors encouraged the authorities to build further on welcome recent steps to enhance the transparency of monetary policy communication.
Given the looming population ageing problems the summary also suggests that the Czech Republic should look for a ``sustainable'' budget policy while giving the pension system a "comprehensive" overhaul.
In view of the coming challenge of population aging, Directors reiterated the importance of early and comprehensive pension and health care reforms. Along with the welcome increase in the retirement age to 65 years, complementary reforms to raise the effective retirement age and promote reliance on private pensions will also be needed. Directors welcomed the introduction of co-payments in health care as a step that should help contain excess demand pressures.