In considering its decision to reduce the base rate at its meting of 16 August 2004, the Council was faced with conflicting trends. On the one hand, favourable developments have unfolded in global and regional financial markets, which have led to an improvement in investors’ propensity to take risks. On the other hand, domestic inflation have passed its peak in recent months and the pattern of economic growth have improved in terms of domestic demand pressure relative to last year. Considering the importance and potential effects of these trends, the Council decided to reduce the central bank base rate by 50 basis points, maintaining its cautious interest rate policy stance.

The Council reviewed the considerable changes taking place in Hungary’s external business environment in the past quarter. Favourable developments unfolded in the summer months in international markets in terms of investors’ assessments of risks. For example, the upward phase of the interest rate cycle in the US took a smooth start, contrary to fears, as it did not entail a decline in investors’ propensity to take risks in emerging-country asset markets. Positive developments commenced in Central and Eastern Europe, simultaneously with conducive global economic events. These may also have contributed to the improvement in the perception of risks carried by forint-denominated investments, which been reflected in the decline in long-term yields, irrespective of domestic economic fundamentals.

In the Bank’s latest economic forecast, inflation declines gradually from its peak in May in the period to the end of the year. Inflation is expected to fall to around 6% by December 2004, with the constant tax price index even expected to be much lower than 6%. Reviewing the details of the current forecast, the Council sees it as important to maintain its cautious monetary policy approach. An agreement on moderate wage growth next year and thorough implementation of the fiscal consolidation programme may prove to be major factors in reducing persistent inflationary pressure.

Wage developments play a prominent role in the inflation process. Although private sector wages turned out to be higher in 2004 H1 than expected, wage inflation is seen to have passed its peak. The Council is confident that a number of macroeconomic factors may be instrumental in more modest wage growth and rapid disinflation in the period ahead. In the government sector, stringent wage and staff policies as well as the prospects of restructuring, announced in respect of the preparation of next year’s budget, may also contribute to the decline in inflation. In the Council’s view, it is extremely important that, while negotiating the proposal for next year’s wages, parties should disregard this year’s one-off increase in prices caused by transient factors, and that they should agree on modest wage growth for 2005. A wage agreement, consistent with the 4% target rate of inflation at end-2005 and enjoying broad-based support, is one of the most important conditions for meeting next year’s inflation target.

Domestic and external business conditions have been propulsive for economic growth this year. The pattern of growth has continued to change positively: general government has been contracting demand significantly, and the propensity of households to save has begun to rise from its earlier low level. The strong pick-up in corporate investment and exports has been a major factor behind this year’s faster economic growth. This has been accompanied by a modest increase in household consumption, following the unsustainable rate of consumption growth in previous years.

In the Bank’s latest real economic forecast, Hungary’s external imbalance improves only slightly in 2004. In the Council’s judgement, developments in external balance and the market’s assessment of balance continue to carry considerable risks. Rapidly rising corporate investment, fuelled by favourable business conditions, have boosted firms’ borrowing requirement, which may cause the current account deficit to be higher than anticipated in 2004 and 2005, despite rising household financial savings and the contractionary impact of fiscal policy on demand. In the future, fast adjustment is required in reducing the general government deficit and increasing household savings, in order for the corporate sector to be able to exploit the opportunities resulting from the upturn in the European business cycle.

In the Council’s assessment, despite the considerable contraction of demand, this year’s fiscal processes may lead to the deficit to be higher than 4.6% as a proportion of GDP unless further government measures are taken. The commitment to reduce the deficit in 2005, undertaken in the convergence programme, requires further considerable policy efforts. Thorough fiscal policy implementation is of fundamental importance for an improvement in external balance.

On the whole, the Council judges that the monetary conditions developing in the wake of the current interest rate reduction, coupled with the required level of fiscal tightness and next year’ moderate wage growth, will be sufficient to meet the 4% inflation target for end-December 2005. Persistent risks to economic equilibrium require maintaining the earlier cautious stance of monetary policy.