28 November 2005

Statement by the Monetary Council

On the prospects for inflation

Sustained low inflation and economic growth around its potential rate, as well as persistent economic imbalance and the resulting uncertainty surrounding the financial markets, currently determine the room for manoeuvre available to monetary policy.

In the Council’s evaluation, the prospects for inflation continue to be favourable. As the temporary effects of the Government’s tax measures will start to wear off, and particularly after early 2006, the annual rate of inflation is likely to be near the 3 per cent medium-term target.

In 2005, core inflation has fallen to historically low levels. As a consequence of intensifying import competition in the tradables sector, low imported inflation and exchange rate stability, there has been a steady decline in prices. By contrast, services price inflation has not fallen materially. At year-end, the consumer price index is expected to be at the bottom of the target range.

Similarly to other countries of the world, rises in oil prices have also had short-run effects in Hungary, which has contributed significantly to the widening of the gap between the consumer price index and core inflation.

Labour market developments, having a key influence on future inflation developments, have been in line with the low inflation environment: they have been a factor facilitating a higher degree of price stability. In respect of wage developments, the Council interprets it as good news that the oil price rises have not been associated with a deterioration in economic agents’ inflation expectations.

A number of reasons make it important to assess short-term developments, in addition to the medium-term outlook. The reduction in VAT rates in 2006 is likely to render it more difficult to monitor underlying inflation developments. Consequently, greater emphasis will be placed on changes in the inflation projection and their evaluation in economic terms. The lower inflation projection for 2006 relative to the forecast in August is explained mainly by the effects of prospective changes in administered prices, tax rules and expected future developments in the prices of unprocessed foods, rather than by the fundamentally different evaluation of macroeconomic and underlying inflation developments.

Due to the effect of the VAT reduction on the general price level, the backward-looking real interest rate may rise temporarily. However, the forward-looking real interest rate, which is calculated on the basis of current yields and inflation expectations and plays a crucial role in economic agents’ decisions, will not change materially, and, consequently, the temporary fall in inflation, caused by the one-off change in the price level, will not automatically imply monetary tightening.

Despite the favourable outlook for the central path, characterised by price stability and stable growth, the Council identifies significant and rising uncertainty in respect of the sustainability of processes in general government finances and external balance. Indirectly, these risks may have a considerable influence on future inflation, due to the size of adjustment required by the sustainable macroeconomic path. In the future, the Council will pay special attention to these sources of risk, and, if the effects on the inflation outlook warrant it, members will place particular emphasis on them in taking their policy decisions.