21 February 2005

Statement by the Monetary Council

At its meeting on 21 February, the Monetary Council reduced the central bank base rate by 75 basis points to 8.25%.

Over the past few months, a variety of fundamentally positive macroeconomic factors have emerged which may contribute to meeting the inflation objectives over the longer term. Reinforcing earlier trends, the fall in inflation has even outpaced expectations. In terms of the future outlook for inflation, the Monetary Council attaches special importance to the long-term persistence of the pronounced disinflation trend underway since 2004 H2. The favourable inflation prospects have provided an opportunity for the Monetary Council to reduce the central bank base rate by 75 basis points, without putting the longer-term inflation targets at risk.

Balanced economic growth may make an important contribution to the success of the longer-term disinflation programme, in addition to monetary policy. However, the uncertainties surrounding the future outlook for Hungary’s economic fundamentals continue to require that monetary policy decisions take into account the risks to macroeconomic balance. Any abrupt change in the currently very favourable international and regional investment environment may increase existing fundamental risks, were investors’ global appetite for risk to deteriorate significantly.

In the Council’s assessment, the fundamental issue has been to prevent the indirect tax increases in early 2004 from leading to sustained inflationary pressure. Members are of the view that last year’s monetary policy conduct has had a major role in persistent fundamental factors, particularly wage developments and the fall in inflation expectations, contributing significantly to the decline in inflation.

In view of the forecast in the Quarterly Report on Inflation, the Council is of the opinion that the inflation targets set for end-2005 and end-2006 can be met with greater certainty relative to the previous quarters. However, meeting the inflation objectives will require disciplined wage developments in the total economy and that nominal wages adjust to the lower outlook for inflation. Monetary policy may greatly help these developments to become permanent by taking predictable actions, fully committed to the achievement of the inflation objective, and by promoting the development of a stable macroeconomic environment.

In terms of the outlook for inflation, the most important issue is related to labour market developments. Labour market tightness has eased since 2004 H2: coupled with a slow increase in the participation rate, the economy’s demand for labour has fallen gradually. These factors have also played a role in the significant decline in wage dynamics.

Economic growth may stabilise between 3%–4% this year and in 2006, consistent with the long-term rate of growth. Simultaneously with this, the pattern of growth is expected to change positively. The slightly lower growth rate is explained by the further decline in household consumption and the significant decline in the sector’s housing investment. In addition to the continued robust rise in corporate investment, net exports may contribute significantly to growth in 2005, in contrast with the experience of previous years.

External equilibrium is expected to improve in 2005, explained mainly by the increase in the household savings rate. The ratio of non-debt financing was over 40% in the first nine months of 2004, due to strong inflows of direct investment capital. This may reduce the risks arising from the country’s external financing requirement.

Although the temporary fiscal measures taken towards end-2004 have reduced the transparency of fiscal developments, the projections presented in the Report suggest that the deficit target for 2005 may only be met by taking additional measures. The latest evaluation by the European Commission has reinforced that the current fiscal processes point to a higher government deficit relative to that outlined in the Convergence Programme.

Investors’ attitudes to risks around the world, and regionally in particular, continue to be extremely favourable. However, future developments are surrounded by a significant degree of uncertainty, as seen in earlier months. Due to the existing high risks to economic balance, potential unfavourable turns in the international environment may cause considerable unease in the domestic financial markets.

The Monetary Council’s future interest rate policy decisions will continue to reflect members’ assessment of risks to equilibrium, in addition to their analysis of the future outlook for inflation.