18 December 2012
Monetary policy over the past quarter
In the period from September to November, the Monetary Council reduced the central bank base rate in three successive steps, by a total of 75 basis points. The Council’s decisions reflected the view that, looking forward, weak domestic demand would have a substantial disinflationary impact on the economy, which would increasingly dominate inflation developments as the cost shocks keeping inflation high in the short term dissipated, thereby helping to meet the Bank’s inflation target. Global risk appetite increased significantly during this period, contributing to a marked decline in Hungarian risk premia and opening up additional room for manoeuvre in monetary policy.
In its November press release, the Monetary Council indicated that it would consider a further reduction in interest rates if the improvement in financial market sentiment continued and the medium-term outlook for inflation was consistent with the Bank’s 3 per cent target.
Macroeconomic developments and outlook
Over the past quarter, the international environment was marked by strongly divergent trends. Financial market sentiment improved, while the euro-area economy fell back into recession this year and the outlook for global activity deteriorated. Official announcements on the ongoing crisis management efforts in Europe and further quantitative easing by the US Federal Reserve both contributed to the increase in investor risk appetite. The Monetary Council expects that the measures taken by European countries to help manage the crisis in the euro area will live up to the expectations and that activity on the Continent will recover gradually over the next two years.
Turning to developments in the domestic economy, there has also been a contrast between improving perceptions of risk and subdued real activity. Output continued to fall in the second and third quarters, though less so than in the first quarter. Domestic and external factors both contributed to the decline in GDP. While the slowdown in external markets continues to hinder Hungarian export growth, actions to reduce private and public debts accumulated in the period prior to the financial crisis, tight credit conditions and the uncertain business environment act as a persistent drag on domestic demand. Meanwhile, risk premia on Hungarian assets fell sharply amid signs of increasing global risk appetite.
In the Monetary Council’s judgement, the outlook for economic growth has deteriorated recently and output is likely to grow only modestly over the next two years. Exports are expected to remain the primary source of growth even as external demand continues to soften, while domestic demand will remain weak. Domestic balance-sheet deleveraging will continue, with consumption and investment likely to fall further, mainly due to tight credit conditions and the uncertain business environment, followed by a gradual recovery from 2014. The potential output of the Hungarian economy is likely to increase very modestly over the next two years, reflecting the sustained weakness in investment and persistently high unemployment.
Labour market activity has strengthened gradually in recent years, but companies have limited ability to absorb the excess supply of labour from the market in a weak demand environment. The rate of earnings growth has picked up sharply this year, with the administrative measures at the start of the year playing a major role. The introduction of the wage compensation scheme for companies cushioned the upward impact of high earnings growth on costs. Nevertheless, unit labour costs increased, leading to a deterioration in corporate profitability.
In the Council’s judgement, the rise in unemployment in recent years partly reflects permanent structural problems, but the labour market is likely to remain loose in the period ahead, even taking account of this factor. In addition to the weak outlook for growth and companies’ poor profitability, the increases in the minimum wage and the guaranteed minimum wage for skilled workers are also impeding a recovery in employment, which is only likely to start in the private sector in 2014. Although the job protection scheme to be launched next year is expected to lower the costs of employing labour under the programme, the Government’s measures, which result in a deterioration in private sector profitability, suggest that companies will continue to adjust going forward.
The consumer price index has remained persistently above the inflation target this year, despite the recessionary environment. The high rate of inflation mainly reflects the effects of the commodity price shocks and the Government’s indirect tax increases, while the pace of underlying inflation remains moderate. Looking ahead, inflation is expected to slow significantly in the short term, mainly reflecting movements in items excluded from the core measure. In the medium term, however, the burden placed on companies by the administrative measures and the minimum wage increase will strengthen the pass-through of higher costs to prices, which in turn may generate cost-push inflationary pressure along the entire production chain.
In terms of the outlook for inflation, there is significant uncertainty about the extent and timing of the pass-through of higher corporate costs to prices in the wake of those measures and the ability of weak domestic demand to offset this.
In the Monetary Council’s judgement, Hungary’s net external financing capacity is likely to rise further in the coming years. This improvement in the economy’s external position will reflect the steady increase in the surplus on goods and services and higher inflows of EU transfers. However, the negative income balance is likely to deteriorate further.
In 2012 and 2013, the fiscal deficit is expected to be broadly consistent with the Government’s target. The measures announced in recent months are likely to lead to a significant improvement in the fiscal balance in 2013. There is considerable uncertainty about the expected size of deficit in 2014. The Government’s commitment to maintaining a low fiscal deficit path may contribute to long-term fiscal sustainability, but the slowdown in potential growth may have the opposite effect.
Maintaining its earlier position, the Council continues to consider it crucial that an agreement between the Government and the European Union and International Monetary Fund be reached, as this would contribute to a sustained improvement in risk perceptions and a decline in yields as well as to the sustainability of government debt and would help support lending activity and improve the investment climate.
Monetary policy considerations
The macroeconomic outlook is surrounded by a considerable degree of uncertainty. With a negative output gap and inflation remaining at high levels, the latest government measures will raise companies’ production costs. One key issue in terms of the medium-term inflation outlook relevant for monetary policy is the ability of the corporate sector to adjust to the increase in production costs against the backdrop of a weaker outlook for growth.
The sustained decline in profitability may prompt companies to cut back further on investment expenditure, which in turn may lead to a slowdown in potential output growth. In the short run, given the amount of capital available to them, companies may choose to restore profitability by improving productivity and reducing wage costs. Furthermore, they may attempt to pass on increased costs into prices, which in turn may imply higher consumer prices. The relative strength of these adjustment channels depends on the extent to which the availability of unused capacity is able to exert discipline on price and wage-setting and inflation expectations are well-anchored. The aim of monetary policy is to ensure that this adjustment takes place against the background of moderate wage and price dynamics, in order to make it possible to meet the 3 per cent inflation target in the medium term. The Monetary Council will closely monitor developments in tax-adjusted inflation.
In the Monetary Council’s judgement, the potential growth rate of the Hungarian economy has fallen significantly recently, reflecting the postponement of investment decisions and financing constraints on companies; there is, however, considerable uncertainty about the magnitude of the reduction in productive capacity available to businesses. If the supply side of the economy has been damaged only to a smaller extent, companies will have less room to pass on increased costs into prices, due to the stronger disinflationary impact of unused capacities. All this may result in more moderate inflation in the medium term, which is more consistent with a looser monetary policy. By contrast, if companies expect the high inflation environment of recent years to persist, the passing on of cost pressures to prices may be stronger. At the same time, economic agents’ higher inflation expectations may also affect wage-setting, in addition to price-setting decisions, which in turn would impede the recovery in profitability in the medium term and would merely lead to a higher nominal path. Corporate adjustment through higher price and wage dynamics can be prevented by tightening monetary policy.
The room for manoeuvre in monetary policy is materially influenced by perceptions of the risks associated with the economy, which have fallen significantly in recent months, mainly reflecting global factors. Looking ahead, the Council judges that there are both upside and downside risks to changes in risk perceptions. The contrast between weak global economic activity and strong risk appetite in international financial markets warrants a cautious monetary policy stance. At the same time, progress with the institutional reforms in the euro area, the reduction in fiscal risks in the US as well as expectations related to the success of domestic fiscal consolidation may increase the room for interest rate policy manoeuvre in Hungary.
In the Council’s assessment, the high level of excess capacity in the economy offsets medium-term inflationary risks. This is supported by the fact that underlying inflation remains moderate and inflation is kept high by transient factors. In the weak demand environment, the corporate sector can adjust to the upward effects of the Government measures on costs only through moderate price increases. Given the slack conditions in the labour market, the rate of earnings growth is likely to slow as the effects of administrative measures fade. Taking these factors into account, the inflation target can be met even if monetary conditions are eased. The Council will consider a further reduction in interest rates only if the improvement in financial market sentiment continues and incoming data confirm that the inflation target is achievable on the horizon relevant for monetary policy.
MAGYAR NEMZETI BANK