The Monetary Council’s statement on macroeconomic developments and its monetary policy assessment

Expecting a strong disinflationary effect from the real side of the economy and a sustained improvement in perceptions of risk, the Monetary Council has started a cautious sequence of interest rate reductions from August 2012.

In the period from December 2012 to February 2013, the Monetary Council continued the series of reductions in the central bank base rate that began last August. With these successive reductions in official interest rates, the base rate fell to 5.25 per cent. The Council’s decisions reflected the view that, looking forward, weak demand would have a substantial disinflationary impact on the economy, which would increasingly dominate inflation developments as the indirect tax increases keeping inflation high last year dissipated, thereby helping to meet the Bank’s inflation target.

In its February press release, the Monetary Council indicated that it would consider a further reduction in interest rates if the medium-term outlook for inflation remained consistent with the Bank’s 3 per cent target and the favourable financial market conditions continued to persist.

Due to the reductions in utilities prices and the strong downward pressure stemming from the demand side, inflation fell below the Bank’s inflation target at the beginning of this year.

There was a general slowdown in global economic activity towards the end of last year. The euro-area recession deepened and the global growth outlook worsened. In developed economies, the expected turning point may be further delayed, with growth only likely to pick up materially in 2014. Measures of inflation in the advanced regions of the world were close to or slightly below central banks’ targets, in line with the weakness in demand. Against the background of low inflation and the subdued outlook for growth, central banks of developed economies continued their stimulus programmes, which contributed to the improvement in financial market sentiment while ensuring that strong capital inflows into emerging market economies were maintained. However, the contrast between economic activity and developments in financial markets still remains. The Monetary Council expects that the crisis management efforts by European economies will live up to the expectations and that activity on the Continent will stabilise in the short term, before picking up gradually.

Hungarian economic data for recent months have been weaker than expected and inflation fell sharply in the first months of 2013. The annual consumer price index dropped below the Bank’s 3 per cent target by February. External and domestic factors both contributed to the decline in GDP towards the end of last year, and temporary cuts in production for idiosyncratic reasons in some sectors of the economy exacerbated the decline. The slowdown in Hungary’s export markets led to a moderation in the pace of export growth, while domestic demand, having key importance in terms of pricing decisions, continued to be subdued. The gradual reduction in debt stocks accumulated during the years prior to the crisis, generally tight credit conditions and uncertainty surrounding the outlook for activity all point to cautious investment and consumption decisions. Reductions in utilities prices at the start of the year led to a material slowdown in consumer price inflation. In the subdued demand environment, companies have limited ability to raise consumer prices. Increases in the prices of non-regulated goods and services were also generally low at the beginning of the year. In the continued benign external market environment, premia on domestic financial assets remained broadly stable until February, before increasing in March.

GDP may grow again in this year, in line with strengthening exports. A pick-up in domestic demand and a more balanced structure of growth is expected from 2014.

In the Council’s judgement, domestic demand conditions remain weak. Taking into account one-off factors significantly affecting some sectors (agriculture, manufacturing) following the deeper-than-expected recession of 2012, economic activity is likely to pick up gradually in the coming quarters. In the short term, the fading effect of last year’s temporary shocks may contribute to the resumption of growth. Exports are likely to remain the most important source of growth. A tangible recovery in domestic demand is unlikely before 2014. Although demand in Hungary’s major export markets is only expected to pick up slowly, the country’s export market share is expected to increase as production related to new capacities built up in the automobile industry in recent years picks up. In the low inflation environment, household real income growth is expected to resume. However, due to the protracted deleveraging process and increased uncertainty, the household savings rate may remain persistently high, and therefore consumer demand is likely to strengthen mainly from 2014. Tight lending conditions and low capacity utilisation may lead companies to postpone investment. Corporate investment is expected to pick up next year, in line with the improving outlook for growth.

Labour market activity is expected to recover in the coming years. However, in the face of the uncertain outlook for demand, companies have limited ability to absorb additional labour supply, and therefore public work programmes may continue to play a key role in employment growth. Companies may choose to restore their profitability by cutting production costs, and wage costs in particular, rather than by raising consumer prices. Persistent slack in the labour market exerts strong downward pressure on wages. The rate of real wage growth may be slower than the improvement in productivity in the coming years. The job protection action plan, implemented from this year, may lead to a general improvement in the chances of employee groups affected by the programme to find a job. However, the Government’s tax measures point to increases in companies’ productions costs and a resulting need to adjust.

The consumer price index may remain below the Bank’s inflation target over the entire forecast horizon. Despite the recessionary environment, the consumer price index remained above target last year. High inflation mainly reflected the effects of commodity price shocks and increases in indirect taxes; meanwhile the pace of underlying inflation was moderate. Incoming data from the start of the year indicate a turning point in inflation, supporting the Council’s view that subdued demand exerted strong downward pressure on prices. Inflation is likely to fall further in the near term, reflecting base effects and reductions in utilities prices by the Government. The upward impact on costs of the increasing the tax burden on certain sectors may pass through to the entire corporate sector along the production chain, which may lead to an increase in core inflation adjusted for indirect taxes. With the output gap remaining negative, the passing on of higher costs into consumer prices may be slow and partial. As a result of these factors, inflation may remain below the 3 per cent target throughout the year and settle close to the target value in 2014.

The net external financing capacity of the Hungarian economy is likely to increase further in the coming years. As a result, the high level of external debt built up before the crisis may decrease further.

In the Council’s judgement, the net external financing capacity of the Hungarian economy is likely to increase further in the coming years. The improvement in the country’s external position reflects the growing surplus on the balance of goods and services, in addition to the steady increase in the amount of EU transfers. Meanwhile, the income account has been deteriorating.

In line with the budget act, the fiscal deficit is likely to be below 3 per cent of GDP both in 2012 and 2013. For the time being, however, there is no accepted budget for 2014. The Government’s commitment to keeping the deficit at low levels contributes to the long-term sustainability of the fiscal position.

The outlook for both inflation and the real economy points to a further easing in monetary conditions.

Over the previous period, inflation in Hungary typically remained above target and economic output significantly below its potential level. In its press releases, the Monetary Council indicated that it judged the disinflationary impact of weak demand to be significant, which would reduce medium-term inflation risks, and therefore the inflation target could be met as the inflationary effects of costs shocks to the economy faded. However, changes in perceptions of risks materially influenced the room for manoeuvre in monetary policy. Ensuring stability of financial markets required a cautious approach to policy.

The inflation data becoming available around the start of the year underpinned the Council’s view that subdued demand exerted strong downward pressure on prices. The outlook for inflation and the real economy point to a further easing in monetary conditions. Therefore, monetary policy can support economic growth consistent with its mandate, without jeopardising the objective of achieving and maintaining price stability. However, volatility in the financial market environment has increased in recent months following the marked improvement last year.

Developments in monetary conditions are surrounded by risks owing to uncertainty related to the level of spare capacity in the economy, developments in bank lending and the global financial market environment.

There is considerable uncertainty around the macroeconomic outlook and financial market developments. The Council judges that the most important risks are related to the size of spare capacity in the economy as well as future developments in bank lending and in risk perceptions.

In the Council’s judgement, the potential growth rate of the Hungarian economy slowed substantially, reflecting the decline in investment activity and the existing financing constraints; however, there is significant uncertainty about the size of the loss of productive capacity. If productive capacity has been damaged only to a smaller extent, then the cyclical position of the economy may be wider. With a wider cyclical position, the ability of companies to pass on cost shocks into prices is more limited and the inflationary impact of cost shocks to companies is smaller, which, in turn, warrants an additional easing of policy.

Developments in lending will have a strong impact on the speed of recovery from the recession. The Council’s past interest rate reductions have led to lower lending rates; however, it is difficult to judge precisely the extent to which this would give a boost to lending. If lower lending rates provide a stimulus to investment activity and bolster household consumption through a pick-up in lending, the recovery of the economy from the crisis may be faster and may not require a further easing of monetary policy overall.

Changes in risk perceptions may materially influence the room for manoeuvre in monetary policy. In the Council’s judgement, a risk is that the dichotomy between benign global financial market conditions and weak real economic performance has not eased. If there is a significant reduction in global risk appetite, risk premia on domestic financial assets may rise significantly.

The Monetary Council voted to reduce the central bank base rate by 25 basis points. In the Council’s judgement, there remains a significant degree of spare capacity in the economy, inflationary pressure is likely to remain moderate in the medium term, and therefore the 3 per cent target can be met with looser monetary conditions. Recent financial market tensions have led to fluctuations in Hungarian asset prices, which cannot be justified by fundamental forces, which continues to warrant a cautious approach to policy. Considering these factors, the Monetary Council decided to reduce the base rate by 25 basis points. The Council will consider a further reduction in interest rates if medium-term inflationary pressures remain moderate and the uncertainty surrounding financial market developments diminishes.