25 September 2012
Monetary policy over the past quarter
Factors pointing in the direction of an easing and a tightening of monetary policy have been present simultaneously since the outset of the financial crisis. The sharp decline in and persistent weakness of domestic demand would warrant a reduction in interest rates. However, continued cost shocks to the price level prevented any sustained fall in inflation, and therefore a cautious approach to interest rate policy was warranted. The global financial market environment and unfavourable movements in domestic asset prices also limited the room for manoeuvre in monetary policy from time to time.
According to the Council’s assessment in June, the factors pointing to an increase or a reduction in interest rates offset each other. In its June press release, the Council had indicated that a cautious approach to monetary policy was warranted by the risk environment and inflation remaining persistently above target and that interest rates could only be reduced after upside risks to inflation subsided.
There has been a sharp deterioration in the outlook for both inflation and the economy over the past quarter. But the global financial market environment improved and, as a result, perceptions of the risks associated with Hungarian financial assets fell markedly. Considering these factors, the Council in August voted to reduce the policy rate by 25 basis points, after maintaining it in July. In its August press release, the Council had indicated that monetary policy could only be eased to the extent that supply shocks to the economy and the upward impact on prices of the Government’s measures did not lead to the build-up of second-round inflationary effects.
Financial market sentiment has improved and the outlook for economic activity deteriorated around the world over the past quarter. Sentiment in international financial markets improved considerably in the summer months. Positive international investor sentiment mainly reflected announcements related to euro-area crisis management, but expectations about a new round of quantitative easing by the US Federal Reserve also contributed to an increase in risk appetite. Despite the signs of improvement in financial markets, however, business survey indicators point to a further slowdown in most economic regions of the world; and there is a risk that the euro-area economy will fall back into recession this year. In the Monetary Council’s judgement, the actions taken by euro-area governments will live up to expectations over time and economic activity in Europe will pick up gradually from 2013.
The contrast between improved perceptions of risks and very subdued economic activity has been reflected in domestic economic developments recently. In the favourable international environment, premia on Hungarian financial assets fell markedly. However, the contraction in economic output continued in the second quarter, although less sharply than in the previous period. The decline in GDP reflected the effects of both external and domestic factors. Actions to reduce private and public debt accumulated during the pre-crisis period, tight lending conditions and the uncertain economic environment continue to act as a significant drag on domestic demand. Production picked up as the large investment projects in the automotive industry were completed, but the slowdown in Hungary’s external markets offset some of the expansionary effect of new capacities on exports. The extremely poor harvest results in agriculture are likely to cause a further deterioration in the outlook for growth this year.
In the Monetary Council’s judgement, the outlook for domestic economic growth has deteriorated recently and output is expected to grow only slowly in 2013. Exports will remain the main driving force behind growth, supported by the expected recovery in activity in Europe. Domestic demand will remain persistently weak, reflecting falling real incomes, continued balance sheet adjustment and tight lending conditions. Consumption and investment are likely to continue to decline next year. As a result of persistently high unemployment and low investment activity, the potential growth of the economy is likely to remain weak next year.
Labour market activity has strengthened recently, reflecting the effects of measures taken by the Government over the past few years. However, corporate demand for labour remained low as economic activity continued to weaken, with the Government’s public work programmes being the only source of growth in employment. Earnings growth has picked up sharply this year after being subdued in previous years. The administrative wage increases at the beginning of the year were an important factor contributing to the pick-up in earnings growth; however, the wage inflation indicators rose, even after excluding the effect of the minimum wage increase. The introduction of the wage compensation scheme for companies has temporarily reduced upward pressure on costs from strong earnings growth; however, rising unit labour costs, associated with deteriorating sales opportunities, have led to cost-push inflationary pressures and restrained employment growth, particularly in sectors producing for the domestic market. The Monetary Council will closely monitor developments in the factors driving the recent sharp increase in earnings growth.
The Monetary Council’s view is that the increase in unemployment during the crisis reflected in part permanent, structural problems; however, even taking this factor into account, slack in the labour market is likely to remain in the period ahead. With the outlook for economic activity remaining weak, growth in demand for labour is expected to be slow. Therefore, nominal earnings growth may moderate as the effects of the minimum wage increase wear off. The job protection action plan, to be implemented next year, is likely to result in a reduction in the employment costs of employees affected by the programme. In the Monetary Council’s judgement, the measures will be sufficient only to cushion the effects of weak activity, and private sector employment is likely to grow at a subdued pace at best.
As the outlook for growth deteriorated, the annual consumer price index remained persistently close to the levels seen at the beginning of the year. High inflation reflects, in part, the effects of the increase in indirect taxes by the Government and the unfolding food price shock. Other measures of inflation, which exclude these effects and capture underlying inflation developments, also rose, with the pass-through of cost shocks into prices being greater than previously expected. Looking ahead, the unfolding food price shock and new government measures are likely to cause the consumer price index to remain at an elevated level through higher excise duties and rises in companies’ production costs. Rising labour costs, increases in taxes on production and higher commodity prices, as well as the downward impact of weak demand on prices all play a role in shaping developments in underlying inflation.
In aggregate, inflation (i.e. the annual rate of increase of consumer prices) is expected to remain significantly above the 3 per cent target for most of the forecast period, with the target only likely to be met in the second half of 2014.
In the Monetary Council’s view, Hungary’s external financing capacity may continue to increase in the coming years. The improvement in the country’s external balance reflects rising EU transfers, in addition to the continuous increase in the surplus on the balance of goods and services; however, the deficit on the income account has been increasing. The investment projects in the automotive industry brought into production will make a significant contribution to growth in net exports, while weak demand will contribute to the high goods surplus through lower imports.
While meeting the deficit target, fiscal policy is likely to bear down on domestic demand this year and next. Although the measures announced as part of the job protection programme have led to a significant amount of fiscal easing in the 2013 government balance, the Monetary Council assumes that the Government will remain committed to meeting the deficit targets, and therefore expects fiscal adjustment to continue. The measures included in the technical assumptions of the projection are likely to raise the consumer price index in 2013 while restraining demand; however, they are necessary to achieve a gradual reduction in Hungary’s risk premia.
A sustainable decline in the fiscal deficit is key to the further reduction in government debt. The Monetary Council continues to consider it crucial that an agreement between the Government and the European Union and the International Monetary Fund is reached as soon as possible in order to reduce the risks associated with financing the government debt and ensure that risk premia fall.
Monetary policy considerations
The outlook for the economy and, consequently, the room for manoeuvre in monetary policy are surrounded by a significant degree of uncertainty. The Council’s monetary policy actions are influenced mainly by the future outlook for inflation, the position of the economy in the current cycle and by perceptions of the risks associated with the economy.
In the Council’s assessment, the economy’s production capacities may have been damaged and the rate of potential economic growth fell significantly as the crisis dragged on. Even as growth remained weak, the output gap closed gradually during the crisis. There is uncertainty in the Monetary Council about the extent to which existing spare capacity in the economy is able to restrain increases in labour costs and prices. Developments in underlying inflation and rises in wages suggest that the disinflationary impact of subdued demand may have weakened recently. However, a number of factors contributed to increases in wages and inflation, and therefore it is difficult to distinguish demand-pull effects form cost-push effects. Consequently, the role of permanent and cyclical factors in the economic downturn can be determined only with a considerable degree of uncertainty. If supply capacity is damaged to a smaller extent, then the disinflationary impact of weak economic activity is greater, and the inflation target can be met by maintaining looser monetary conditions.
Another important question in terms of monetary policy decisions is the extent to which continued cost shocks to the economy alter economic agents’ inflation expectations. If agents expect inflation to remain persistently higher, then the second-round effects of the cost shock may be stronger, nominal wages may increase and underlying inflation may rise. In that case, tighter monetary conditions are necessary to offset unfavourable developments.
Changes in the financial market environment may also have a significant influence on monetary policy decisions. In terms of future developments in risk perceptions, the Monetary Council judges that there is a chance of both an improvement and a deterioration in the current situation. Greater-than-expected success in European crisis management and domestic economic policy measures to mitigate the risks to debt financing may help reduce risk premia. However, a failure or significant delay in reaching an agreement between Government and the European Commission and the IMF may lead to a sharp rise in risk premia.
A majority of Monetary Councils members judge that there continues to be a significant margin of spare capacity in the economy. Therefore, weak domestic demand dampens the direct inflationary impact of cost shocks. The inflation target is likely to be met as the direct effects of cost shocks wear off. The measures to address the European sovereign debt crisis will contribute significantly to the improvement in the global financial market environment, which in turn will result in a sustained fall in domestic risk premia. Overall, expected developments in inflation and financial markets as well as persistently weak demand warrant an easing of current monetary conditions. The Council will consider a further reduction in interest rates if the improvement in financial market sentiment persists and medium-term upside risks to inflation remain moderate.
MAGYAR NEMZETI BANK