In the Monetary Council’s judgement there have been favourable developments in inflation recently. Inflation outlook for the coming years is also benign. Fall in core inflation, indicative of persistent trends, was attributable to a stable exchange rate of the forint, increasingly strong import competition that reined in prices and moderate growth in consumer demand. At end-2005 inflation is likely to be 0.5 percentage point lower than the 4%-inflation target set earlier. Favourable trends will persist in 2006. Under the MNB’s forecast, inflation will be in the lower domain of the target range even if the direct impact of the announced VAT rate cuts are discounted; temporarily, inflation will be further reduced by the one-off effect of VAT rate cuts. It is expected to stand at around the 3%-medium-term target. However, there is significant uncertainty over the outlook.

The measures recently announced by the government are highly likely to affect trends in inflation, the business cycle and the equilibrium. They will contribute to more rapid economic growth mainly through invigorating household consumption, as several components of the package are expected to increase household real income. Meanwhile, the Monetary Council envisages stable growth in the external market factors of the business cycle. Consistent with balanced business cycle prospects, exports and corporate fixed investment will continue to grow at a steady rate. Higher consumption and economic growth, somewhat faster than long-term trends suggest, point to higher demand-pull inflationary pressure.

On the supply side, the picture is somewhat more intricate. Although it is hard to predict the 2006 impacts of the announced minimum wage raise, recent on-going decline in wage inflation is expected to continue after a temporarily halt. From 2007 on, factors of disinflation may become dominant in the labour market if the envisaged tax cuts reduce labour costs.

However, there is considerable uncertainty over outlook for 2006 and 2007. It is still to be seen how the government intends to offset the adverse impacts of the package on fiscal balance in the years to come. For lack of genuine adjustment, a materially and persistently stronger fiscal demand effect and higher current account deficit can be expected, which poses an indirect risk to inflation and stability through a potential adverse impact on investor perception. In the Monetary Council’s opinion it is crucial that, in the budgeting process and during budgetary execution, the offsetting of the announced measures should be implemented in a manner that reassures financial markets as well. In this case fiscal measures will only have direct inflationary effects, and following a temporary decline in 2006, inflation may stand at around 3%.

Although the equilibrium position of the economy has improved, the current account deficit continues to be high. The impact of the unfavourable equilibrium situation is offset by very strong demand in the global capital markets for assets in higher-risk investment categories. Moderation in risk premia on forint-denominated assets has, over the past year, allowed for the possibility that the Monetary Council can lower its key rate. Despite an outstandingly high risk appetite for emerging markets and especially for the CEE region over the past months, the risk of an unfavourable turn cannot be ruled out either. Such a risk may be further amplified by domestic indicators suggesting persistent imbalances.

In addition to the indirect inflationary impact of a potentially weaker risk appetite, other trends may also result in higher inflation than what can be foreseen now. The Monetary Council considers rapid increase in consumption and a rise in the minimum wage entailing wage compression that feeds through over the longer term as key risk factors. If, however, price level reduction generated by VAT rate cuts is incorporated into inflationary expectations, inflation may well stand at a lower level.

Experienced also in other new member states of the EU and related to changes in the accounting approach attributable to Hungary’s EU accession, uncertainty over foreign trade data renders the assessment of the external balance difficult.

Based on the above, the Monetary Council decided to lower the central bank base rate by 50 basis points to 6.25%.

Budapest, 22 August 2005

                                                                                    Magyar Nemzeti Bank

                                                                                        Monetary Council