22 November 2004

Factors strongly influencing inflation, the positive turn in inflation expectations and the current global investment climate have all contributed to the Monetary Council’s decision to reduce the base rate by 50 basis points at its meeting on 22 November.

The rate of consumer price inflation has slowed down significantly over the past months. As an effect of the extremely positive investment climate, both internationally and regionally, yields required on forint-denominated investments have fallen, despite uncertainties in respect of Hungary’s external equilibrium position remaining.

The November 2004 issue of the MNB’s Quarterly Report on Inflation is being published simultaneously with the Council’s interest rate decision. The Report includes staff’s inflation projection as well as a discussion of the recent developments in the financial environment. In the current forecast, inflation falls in 2005–2006. The decline in the rate of price rises is expected to be particularly marked in early 2005. In the Monetary Council’s assessment, inflation will be close to the 4 per cent and 3.5 per cent targets at end-2005 and end-2006 respectively.

The recent improvement in inflation expectations is a positive development. Judged against the background of this year’s increases in indirect taxes (mainly in the VAT and excise duties) which carried the risk of expectations remaining stuck at a high level through rises in consumer prices, the fall in firms’ and households’ inflation expectations is a particularly favourable development. According to evidence of the latest polls, this danger appears to have subsided recently.

The forint exchange rate has been stronger and more stable relative to last year. In the Council’s view, this has also played a role in the fall in inflation, which, beyond its direct effects, has contributed to the slowdown in the rate of price rises by dampening inflation expectations. Consequently, the exchange rate has also contributed to curbing the secondary effects of the indirect tax increases influencing inflation.

In the Council’s evaluation, in 2005 the real economy will shift towards a growth path consistent with the expansion of its production capacities. In the MNB’s forecast, GDP grows by 4 per cent this year, by 3.7 per cent next year and by 3.5 per cent in 2006. Compared with 2004, the contribution of fixed investment to growth is likely to be lower and that of exports higher. Household consumption is expected to grow at a more modest pace following the previous years’ rate.

The slowdown in domestic demand fuels disinflation and counterbalances the high, though slowing, growth of corporate wages costs. The deep decline in labour reserves has also contributed to the fast increase in nominal wage costs: competition among firms for labour has driven up wages. Looking further ahead, the Monetary Council expects a slowdown in the growth rate of nominal wage costs, building on the sustained downturn in inflation expectations, the disciplinary power of tight monetary conditions and the adherence to the proposal for a 6 per cent nominal wage increase agreed in the National Interest Reconciliation Council.

The Monetary Council expects a slow improvement in Hungary’s equilibrium indicators. Although in the current forecast the current account deficit-to-GDP ratio remains level in 2004 with the previous year, the country’s external financing requirement is likely to fall in 2004–2005.

Fiscal policy may play a key role in reducing the current account deficit. The Council considers it important that fiscal policy should adhere to the path set in the convergence programme and contribute to the improvement in Hungary’s external debt position through a contraction of demand. However, in the Council’s view next year’s budget and tax bills in their current forms do not create the conditions for this, and further corrective measures will be required.

International cyclical developments have been conducive to the improvement in the country’s equilibrium position. However, the strong global economic recovery is surrounded by considerable risks. If the cyclical position of Hungary’s major trading partners, particularly that of the euro area, turns out to be worse than expected over the near term, it would expose Hungary’s currently fragile external equilibrium position to higher stability risks.

Currently, international financial markets are dominated by investor enthusiasm. Risk appetite continues to be high, which is favourable for current account deficit financing. In addition, long-term forint yields have fallen in recent months.