19 January 2009

1 At its meeting on 19 January 2009, the Monetary Council reviewed the latest economic and financial developments and reduced the central bank base rate by 50 basis points from 10.00% to 9.50%, with effect from 20 January 2008.

Over the period ahead, the Council expects inflation to be below the medium-term target and the economy to suffer a sharp downturn.

Data released over the past month indicate that the outlook for the real economy has deteriorated further. Domestic industrial production fell more sharply than expected; and indicators of global economic activity foreshadow a weaker outlook for external demand. As an effect of these factors, it seems likely that inflation will be lower than previously expected.

Monetary policy should continue to take particular attention to preserving the stability of the financial intermediary system and to ensuring that capital flows remain balanced, in addition to focusing on inflation and real economic performance. Risks associated with external financing have recently declined gradually, coupled with an improvement in the ability of the financial intermediary system to absorb stress. However, there remains considerable uncertainty, with limited room for monetary policy manoeuvre.

The Monetary Council took its decision to ease policy further consistent with the projections of an economic downturn and a sharp decline in inflation. The base rate may be reduced further in the coming months, if capital flows remain undisturbed and the stability of the financial intermediary system is preserved.

2 The abridged minutes of today’s meeting will be published at 2 p.m. on 13 February 2009.

3 The Council’s assessment of inflation performance in 2008

Although the consumer price index fell significantly over 2008 as a whole, it stayed consistently above the Bank’s 3 per cent medium-term inflation target, and, except in the final month of the year, it even remained outside the ±1 per cent tolerance band. The annual average rate of inflation was 6.1 per cent; however, the consumer price index fell to 3.5 per cent in December.

Inflation moved above the tolerance band in the second half of 2008. The high rates of inflation in the years 2006–2007 had in large part been caused by increases in administered prices, closely related to the fiscal adjustment measures. By contrast, in 2008 high inflation was due mainly to cost shocks of global origin, which, however, moderated in the second half of the year.

Food and commodity prices rising at extremely rapid rates and with unpredictable magnitude up to mid-2008 played an important role in inflation moving above target. Monetary policy may influence inflation only with a lag – 2008 inflation developments were influenced mainly by the monetary policy actions of 2006–2007. The inflationary effects of rises in food and commodity prices would only have been fully offset by a rapid and drastic tightening of policy. However, first, there was no scope for such action up to February 2008, due to the intervention band and, second, the Monetary Council saw no reason to do so, because of the significant real economic costs involved. The Council tightened policy in an effort to avoid the second-round effects of cost shocks.

But the fall in inflation in the period to autumn 2008 was slower than the Bank expected, even after eliminating the effects of the unforeseen cost shocks. One reason for this was that back in 2007, the MNB thought the prospective decline in domestic demand in the wake of fiscal adjustment would lead to a sharp slowing in the rate of inflation. The eventual fall in demand did reduce inflation; however, the magnitude of the reduction in inflation was smaller than expected. And although the Bank continuously pointed out that the potential rate of growth was slowing, the magnitude of this was greater than expected. Consequently, the decline in demand over the period to autumn 2008 did not lead to a significant increase in spare capacity in the economy, and therefore, the fall in inflation had a less pronounced effect.

Labour market developments also contributed to lower-than-expected inflation. In its wage-setting decisions, the private sector did not adjust fast enough to the weaker prospects for economic activity, as suggested by unit labour cost data. The sustained high inflation rates of past years may also have kept economic agents’ inflation expectations at high levels.

In the Monetary Council’s view, the easing in inflation in autumn 2008 will continue, and the inflation target may be met in 2009. The Council will be committed to achieving a sustained reduction in inflation. In the future, economic agents taking their price and wage-setting decision consistent with the Bank’s inflation target may contribute to the maintenance of price stability.


Monetary Council