The most important objective of overall economic policy is a stable economic growth that is sustainable over the long term. Central banks can support this goal best by keeping inflation low and stable through conducting a predictable and credible monetary policy.
This also underlies the Central Bank Act, which provides that ‘the primary objective of the MNB shall be to achieve and maintain price stability’, in line with widespread international practice as well as European Union legislation.
There is general consensus on both economic theory and the international practice of central banking that monetary policy instruments alone are insufficient to exert a lasting influence on both economic growth rate and employment. Although a temporary impact cannot be ruled out over the short term, monetary policy can only affect nominal variables such as inflation and the nominal interest rates over the longer term. The underlying reason for this is that inflation expectations will, over time, adjust to a changed environment.
Inflation may do serious damage to the economy via two interrelated channels. One is that higher inflation increases ‘menu’ costs and ‘shoe-leather’ costs and leads to diverse forms of distortion in the economy, e.g. in the tax regime and the accounting system. Higher inflation implies higher nominal interest rates and, consequently, higher amounts of loan repayments for borrowers when measured against disposable income. This, in turn, leads to shorter loan maturities and thus to a decrease in the depth of financial markets.
Furthermore, high and variable inflation interferes with the information content of prices, which is the very foundation of a healthy market economy. As a consequence, assessments of changes in demand and supply become distorted, thereby impeding the efficient use of resources. Moreover, volatile inflation may lead to an unintended redistribution of incomes. Another problem is that uncertainty over inflation entails the shortening of contract terms, which has adverse impact on economic activity. The fact that the two channels reinforce each other adds to the costs of inflation, as higher inflation usually leads to wider fluctuations and increases inflation uncertainty.
Realising the limitations of monetary policy’s impact on the real economy as well as the costs of inflation, developed economies and an increasingly large number of emerging countries define price stability as the ultimate objective of monetary policy. Price stability is defined as low, but not zero, inflation, explained by downward nominal rigidities, the risk of deflation, the need for positive nominal interest rates and statistical measurement errors in the consumer price index. Based on these considerations, price stability is set at around 2%–3% by the majority of central banks of countries with inflation targeting regimes, while the European Central Bank (ECB) defines it as ‘below, but close to 2%’.
The MNB set, with effect from 2007, an average 3% increase in consumer prices as its medium-term inflation target consistent with price stability. The Bank’s inflation target is in line with international practice, but is slightly higher than the level of inflation defined by the ECB as consistent with price stability. The reason for this difference lies in the convergence process of the Hungarian economy, which is accompanied by a wider gap between tradables and non-tradables inflation. Growth in emerging economies is associated with the catch-up with developed countries in terms of prices, which may cause additional inflation relative to developed countries.