21 January 2008
1 At its meeting on 21 January 2008, the Monetary Council reviewed the latest economic and financial developments and voted to leave the central bank base rate unchanged at 7.50%.
2 The Council maintains its view that, as a consequence of the fiscal measures and the cost shocks of the recent past, inflation may be above target and economic growth below potential in 2008. With the unwinding of the first-round effects of these shocks, the inflation rate may slow to close to the 3% target in 2009; however, a potential rise in inflation expectations continues to represent an upside risk.
Consumption demand continued to be weak, according to recent retail sales data. Industrial production appears to have slowed, with the slowdown in the rate of export growth being a contributory factor, in addition to the weakening in domestic demand. Downside risks to growth may increase, due to uncertainties about the outlook for global economic activity.
CPI and core inflation both rose relative to November. This increase largely reflected rises in food and vehicle fuel prices, continuing the trends seen earlier in the year. However, inflation of other product prices over which monetary policy has most control has not accelerated. Two factors are of key importance for the future prospects for inflation: (i) the way in which one-off shocks will influence economic agents’ price and wage setting decisions and (ii) the extent to which policy will be able prevent a rise in inflation expectations. Inflationary developments in the world economy, coupled with further increases in administered prices in Hungary, constitute further risks to inflation. Private sector wage growth slowed somewhat in November, mainly on account of lower-than-usual bonus payments. The recommendation of the Interest Reconciliation Council foreshadows a further moderation in wage growth. In contrast, the increase in the minimum wage for skilled workers represents an upside risk. Price and wage decisions, consistent with subdued domestic demand, would contribute to a fall in inflation and, indirectly, they would provide a boost to growth.
There remains considerable uncertainty in international financial markets. The re-pricing of credit risk is likely to continue in the coming months. International investors’ willingness to take risk in emerging markets has moderated recently.
The Monetary Council’s decision to leave the policy rate unchanged reflects its assessment of the risks associated with inflation expectations and international capital markets. The future path of interest rates depends on the degree to which expectations will feed through to inflation and on the direction future developments in international money and capital markets will take.
3 The abridged minutes of today’s Council meeting will be published at 2 p.m. on 15 February 2008.
4 The Monetary Council’s assessment of inflation performance in 2007
Consumer price inflation remained above the 3% medium-term target throughout 2007 and even exceeded the ±1% tolerance band. Annual average inflation was 8%.
Monetary policy actions affect inflation only with a lag. Generally, the strongest effect is felt after about 5–8 quarters. Consequently, 2007 inflation developments were influenced mainly by the decisions the Council took in the period between 2005 H2 and 2006.
The period end-2005–2006 H1 was characterised by a benign inflation environment, which, however, was achieved in combination with unsustainable fiscal policy over the long term. Although the Monetary Council emphasised the need for fiscal adjustment on several occasions, the structure of such an adjustment programme remained unknown for most of the period. International experience has shown that there are significant differences in fiscal adjustments in respect of the degree to which monetary policy should react to such measures. For this reason, monetary policy adopted a wait-and-see approach.
Factors such as increases in VAT and certain administered prices as well as reductions in price subsidies, played an important role in the fiscal adjustment programme launched in the summer of 2006. These in turn led to a sharp rise in inflation in 2007. The Bank decided not to neutralise the one-off, direct upward effects on prices of the measures, as it would have led to excessive growth sacrifice. The Council, therefore, chose to allow inflation to rise temporarily above the target in 2007. However, it could not disregard the fact that the price increases might cause a sustained rise in expectations, which threatened to lead to an indirect, persistent rise in inflation. Partly to prevent such a situation, and partly because of the rise in risk premia, the Monetary Council raised the base rate in small steps, by a total of two percentage points.
Other, unforeseen shocks also contributed to inflation rising above target, in addition to the fiscal measures. An example is the increase in food prices, explained, among other things, by adverse weather conditions in 2007 and a rapid expansion in the global demand for food. Rises in international energy prices also had inflationary effects, particularly as they also fed through to administered prices. Without the increases in administered prices as well as in energy and food prices above expectations, inflation would have exceeded the target by a much smaller margin.
Although in 2006 the Bank decided not to offset the upward effect on prices of the one-off and unforeseen shocks, it subsequently pursued a course of policy which aimed to ensure that inflation expectations did not reflect the 2007 price rises over the medium term. For this reason, in 2007 the central bank base rate consistently exceeded earlier market expectations.
In the future, monetary policy will monitor carefully changes in inflation expectations, and will make every effort to deliver price stability in the medium term. By achieving and maintaining price stability, the Bank can best contribute to long-term economic growth and a predictable macroeconomic environment.
MAGYAR NEMZETI BANK