20 November 2006

In the Monetary Council’s central projection, inflation rises further significantly over the short term, before easing back gradually. Nevertheless, on the assumption of monetary conditions in the November issue of the Quarterly Report on Inflation, inflation is likely to be above the 3% medium-term target throughout the entire forecast period.

Despite further policy tightening over recent months, the longer-term outlook for inflation has improved only slightly. The main reason for this can be traced to the fact that the indicators of underlying inflation developments, derived by eliminating the effects of increases in taxes and administered prices, have been rising faster than expected. Price rises have affected a broad range of products, which may point to a sustained rise in inflation expectations. As for the longer-term prospects, however, it is encouraging that, according to the core measure of inflation, there is the likelihood that inflation may slow markedly in the second half of the forecast period.

The outlook for inflation has been affected negatively by the pick-up in private sector wage growth in recent months. Although the data point to rising wage inflation even after eliminating the effects of bonus payments, loose labour market conditions may act to reduce wage inflation risks over the longer term.

As an effect of the Government’s fiscal measures and worsening external business conditions, the rate of economic growth is expected to lag behind its potential in 2007 and 2008 by a wide margin. Deficit reduction is expected to contribute to restoring external and domestic balance and it may help to bring down inflation over the longer term by restraining consumption.

Investors’ mood around the world has improved in recent months, which has played a role in the appreciation of the forint exchange rate and the fall in long-term yields, in addition to the market’s more benign assessment of fiscal adjustments and monetary policy tightening. If recent developments in the money and capital market persist, it would mitigate the risks of higher inflation.

In the Council’s judgement, overall, there continue to be upside and downside risks to the expected future path of inflation. The decline in macroeconomic demand and its downward effect on inflation may prove stronger than currently assumed, which adds to the likelihood of a lower inflation path developing. For the Monetary Council, however, the risk that one-off price increases might lead to a sustained rise in economic agents’ inflation expectations remains one of the most important upside risks to inflation. In this regard, the Bank will only be able to meet its medium-term inflation target with the lowest output loss, as long as pay awards in the private sector do not deviate too far from the rate justified by real economic developments and the return to low inflation in the period ahead.

Monetary Council