The Monetary Council requested analyses to assist in evaluating the long-term macroeconomic developments bearing on the fulfilment of the inflation criteria for EMU membership. The real costs of disinflation depend to a great extent on the existence of 'structural' inflation, which is primarily linked to non-monetary factors and can hardly be controlled by conventional anti-inflationary policy tools. Some specialists believe that economic transition, convergence and EU accession require price adjustments in several areas. These factors may exert substantial pressure on domestic prices within a short period of time. This paper of the Background Studies series deals with the issue of "inflationary tensions" inherent in domestic food prices. Other sectors, such as energy and tax harmonisation, will be covered later.

This analysis will take a look at the potential effects of EU accession on food prices, aiming to assess whether domestic food prices conceal an 'inflationary bomb" which could be ignited by the accession. It is widely held in Hungary that joining the EU will cause the level of domestic food prices to rise at a rapid and strong pace vis-a-vis EU prices. Arguments can be divided into two categories. On the one hand, the intervention prices of the Common Agricultural Policy (CAP) are likely to exert upward pressure on certain domestic agricultural producer prices. On the other hand, current consumer price differentials between domestic and EU prices will disappear. The question carries great significance on account of Hungary's ambition to join the euro area, as the next stage of integration following entry into the EU. Meeting the relevant Maastricht criteria requires, inter alia, reducing inflation to a very low level. As the two years following EU accession are crucial from the point of view of satisfying the inflation criteria, this period has been chosen as the focus of the following analysis.

We have found that, by the late nineties, domestic agricultural prices of the products most relevant for the consumer price index had approached those in European countries. This was not so much due to the price-equalising role of free trade, but rather to the fact that, over the past decade, domestic producer prices have been flat to rising in terms of euro, simultaneously with a downward movement in European price levels. This process has gained further momentum from a persistent appreciation in the exchange rate of the forint. Although some products more crucial to domestic consumption (like sugar beet, for instance) are also likely to increase in price in the aftermath of the EU accession, we do not expect this to generate widespread inflationary shocks. Finally, there are also prices, (of fodder, for instance) which might increase as a result of Hungary's adoption of the common agricultural policy in the wake of the EU entry, but, due to high meat prices, this is not likely to feed through to inflation.

On the other hand, the retail price level of food products in Hungary is well below the EU average. The reason for this seems to be lying in the high weight of non-tradable input factors (such as wages, land and supplementary services) or other local factors (such as differences in the degree of perishability and in consumer preferences, etc). As the price level of the former tends to depend on the degree of economic development, food prices may permanently vary across countries at different stages of development. The latter factors tend to hamper goods arbitrage in general. Over the longer term, however, prices in this category are also likely to be equalised with the consumer prices of less developed EU countries, simultaneously with the overall catching up of the Hungarian economy.

As for land prices, they are expected to increase in conjunction with the liberalisation of the land market. Nevertheless, this process is expected to evolve only years after the prospective dates of EU (and EMU) entry, due to the requested derogation, and even then no inflationary tension is likely to be generated as land prices are determined by food prices and not the other way round.

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