Inflationary pressure has eased and the risk that inflation would be in excess of the Bank’s 4% target at end-2005 has reduced in the period since the February Report. The consumer price indices (March: 6.7% year on year; April: 6.9% year on year), released by the CSO in recent months, have turned out to be slightly lower than expected. At 4.7%, the constant tax price index (CTI) was lower in April than the consumer price index for end-2003. In the Monetary Council’s judgement, it is important that economic agents adjust their decisions to the actual outcomes in the CTI.

Contributing to a positive change in the inflation trend, the slowdown in household consumption started earlier and it proved slightly more robust than previously assumed. After rising rapidly in the previous two years, the rate of real wage growth has fallen. This and the contractionary impact of general government on demand have been slowing consumption expenditure, despite the recent improvement in business conditions.

Consequently, the modest rate of consumption growth suggests that a further fall in inflation is in prospect.

On the supply side, there have been trends facilitating the fall in inflation. The rapid improvement in productivity and, consequently, the positive changes in unit labour costs, have contributed to disinflation. The increase in the activity rate has reduced labour market tightness. Despite these positive effects, future developments in the labour market constitute the most critical factor of risk to next year’s inflation.

There has been a slow improvement in Hungary’s equilibrium position and in the assessment of risks the economy is facing. This has allowed for the Bank to lower its key policy rate, in a series of steps, by a total 1 per cent. If the economy continues to progress along the forecast path, i.e. fiscal adjustment continues, wage growth slows further, the household sector’s propensity to save increases and the country’s risk assessment improves further, moderating inflation risks may provide room for further reductions in interest rates after rising to high levels towards late last year. But the risks to inflation and the capital market continue to require a cautious monetary policy approach.

The capital market’s assessment of the Hungarian economy has remained unstable, which carries an additional factor of risk. External events, such as the decline in investors’ risk appetite in international financial markets, with the interest rate cycle nearing its end in the major economies, have also contributed to variations in risk assessment. That, in turn, may lead to a rise in the required risk premium on forint-denominated assets. But, eventually, it is Hungarian economic indicators that play the most important role in turns in risk perception. Despite the improvement in the financing pattern of the current account deficit, economic, mainly fiscal, measures are required to achieve a sustained reduction in macroeconomic imbalances, with an objective to lower the deficit. The Monetary Council expects the Government’s measures at end-2003 to influence Hungary’s external balance in 2004 H1.

The tightening of conditions of the subsidised house purchase scheme in 2003 is likely to improve households’ net saving position in 2005. However, the private sector’s borrowing requirement is expected to increase over the medium term, as higher investment spending by the corporate sector will be coupled with increased borrowing. This will have to be counterbalanced by the planned reduction in the general government deficit.

The Government has submitted its Convergence Programme to the European Commission. The Programme foresees a reduction in deficit from 4.6% as a proportion of GDP in 2004 to 4.1% in 2005. Consistent with this, the Government has rescheduled Hungary’s entry into the euro area for 2010, which will require meeting the 3% deficit criterion in 2007–2008.

The general government borrowing requirement is likely to fall considerably in 2004 relative to 2003. However, based on the recent macroeconomic developments, the ESA based deficit as a proportion of GDP is likely to exceed the 4.6% target, if no further fiscal measures are taken. Meeting the target for 2005 will also require further major actions, given the need for offsetting the Government’s predetermined measures and the effects of actions, already decided, resulting in a higher deficit. Implementing the envisaged inflation path is extremely important not only from the perspective of Hungary’s commitments towards the EU and adopting the euro, but also for reducing the current account deficit to a sustainable level over the long term.