22 August 2005

The Government and the Magyar Nemzeti Bank have agreed to adopt a medium-term target for inflation for the period starting in 2007, expressed as a 3% rate of increase in consumer prices measured bythe Consumer Price Index regularly published by the Central Statistical Office.

The MNB conducts its monetary policy under an inflation targeting regime, and it aims to achieve the targets set jointly with the Government within this framework. In the disinflation period of the previous years, inflation targets were set annually. But recent success with reducing inflation has offered the opportunity for the Government and the Bank to set the target at a level consistent with price stability for a longer period. The most important advantage of the continuous inflation target is that it ensures a predictable environment for economic agents, helps to anchor inflation expectations and, as a result, it contributes to keeping inflation at a permanently low level which is in line with price stability.

The conditions for price stability are assumed to hold if economic agents can reasonably expect inflation to remain low and stable looking ahead over a longer period. Price stability does not mean inflation around zero – excessively low inflation does have risks to economic activity. The Government and the Bank are in agreement that a 3% inflation rate on average over the medium term is consistent with price stability in Hungary. The 3% target is somewhat higher than the inflation accepted as price stability in the euro area as a whole. The difference is justified by the price catch-up accompanying Hungary’s real economic convergence, which is explained mainly by the relatively faster increase in domestic services prices, considered to be low by international standards.

This inflation differential, caused by economic convergence, may change over time. For this reason, it is useful to periodically review the medium-term inflation target. The medium-term inflation target recently set by the Government and the Bank will be reviewed at the time of Hungary’s entry into ERM II, the European exchange rate  mechanism, but in three years’ time the latest. Entry into ERM II is an important stage on the road to adopting the euro, which will entail a change to the monetary policy framework. The 3% inflation target is expected to be an appropriate starting point for meeting the Maastricht inflation criterion.

Monetary policy is only able to influence inflation developments with a certain time lag. The Monetary Council decides on the level of interest rates in a forward-looking manner, taking account of likely future developments in inflation over the following 5–8 quarters. This ensures that inflation reverts to close to the 3% target rate with a high degree of certainty. However, government measures or transient external shocks may move inflation away from the 3% target. Some of these shocks are relatively short-run, and they do not have a major influence on longer-term inflation developments. As offsetting such transient factors may be associated with significant and undesirable volatility in real economic activity, the MNB will not take measures to counteract one-off shocks to the price level. Nevertheless, it aims to prevent the development of second-round effects, in order to ensure that inflation remains stable over the long term.

Fluctuations caused by unanticipated shocks should also be taken into account when it comes to assess whether the inflation target has been met. To this end, the Government and the Bank agreed that a maximum ±1 percentage point deviation of the Consumer Price Index from the 3% inflation target is acceptable in terms of  maintaining price stability. The Bank will assess the meeting of the inflation target on a quarterly basis, in statements by the Monetary Council issued simultaneously with the publication of the Quarterly Report on Inflation, and on a yearly basis in its Annual Report.

                                                                                   Magyar Nemzeti Bank

                                                                                        Monetary Council