19 June 2006

1.    At its meeting on 19 June 2006, the Monetary Council considered the latest economic and financial developments and decided to increase the central bank base rate by 25 basis points, from 6.00% to 6.25%, with effect from 20 June 2006.

In the Council’s evaluation, the future outlook for the economy and inflation has changed significantly since publication of the May issue of the Quarterly Report on Inflation. The latest official inflation data and the package of fiscal measures announced by the Government point to marked upward risks to inflation. In addition, investor demand for forint-denominated assets has continued to fall recently, as a consequence of steadily rising yields in major international capital markets and the continued uncertainty about the assessment of risks associated with Hungarian economic performance.

In May 2006, the consumer price index rose to 2.8% year on year, coupled with an increase in trend inflation, an important guide to assessing the country’s underlying macroeconomic position. And although firm conclusions cannot be drawn based on any one month’s figure, the fact that all of its major components are pointing upwards suggests that the pattern of inflation has been unfavourable in recent months.

The package of austerity measures, announced by the Government on 10 June, is expected to have a significant, positive effect on the budget balance and consequently on external equilibrium. As the Hungarian economy has been vulnerable to its twin deficits in recent years, the reduction in external and domestic imbalance may contribute to an improvement in the country’s risk assessment and an increase in the room for monetary policy manoeuvre over the longer term. However, in the Monetary Council’s judgement the composition of the Government’s budgetary adjustment programme is unfavourable in several respects.

First, the planned deficit reduction is based mainly on tax increases, which cannot be viewed as a sustainable and therefore credible solution over the longer term, taking into account the high taxes on income and fiscal burdens on employment. An improvement in economic balance could only be sustained if it was accompanied by structural reforms and measures to cut expenditure. Second, the Council expects the most important measures of the adjustment programme to boost prices significantly. Due to their direct and second-round effects on inflation, strong increases in certain administered prices and several other measures of the programme may create an environment which is difficult for monetary policy to assess precisely.

In the Bank’s expectation, inflation will rise significantly in 2007 in the wake of the adjustment package and will exceed the Bank’s inflation target by a large margin. All this poses upside risks to wage inflation and carries the danger that inflation will rise above the target in 2008, due to the spillover effects. A moderate wages policy by the Government may mitigate these influences.

The recent rise in yields in major international markets has added to the vulnerability of the Hungarian economy. The announcement of government measures has not yet been sufficient to alleviate investors’ concerns. In its conduct of monetary policy, the Council will take special care that the prevailing yield spread reflects the required risk premium on forint-denominated assets and thus ensures a certain degree of protection in an international environment for investments which has become less benign recently.

Weighing these considerations, the Council took a decision to increase the central bank base rate.

2.    The minutes of this Council meeting will be published at 2 p.m. on 7 July 2006.


Monetary Council