Monetary Policy in Hungary

Hungary's central bank kept the European Union's highest benchmark interest rate unchanged yesterday after surging food prices and rising oil costs, coupled with stubbornly high annual wage increases have meant that inflation has not come down the way everyone was hoping it would.

The bank's 12 policy makers, led by President Andras Simor, left the two-week deposit rate at 7.5 percent yesterday, deciding to hold the rate as it was, although the possibility of a quarter-point cut was also discussed.

A summer drought which ravaged crops and drove food prices higher have not helped the bank's efforts to subdue inflation. Neither has the rising cost of crude oil, and both these factors make it difficult for policy makers to lower borrowing costs as the bank looks to avert second-round effects.

``The opportunity to lower interest rates will open when economic processes suggest that the risk of inflation effects spreading through expectations will lessen and international money and capital market tendencies turn out more favorably for the Hungarian economy,''

The biggest problem, however, is the background isssue of the non-forint denominated debt (also know as the Swiss mortgages issue) since it is the existence of this liability on the household balance sheet at this point which makes it virtually unthinkable for the central bank to contemplate any aggressive monetary easing for fear of a provoking fall in the forint and creating large scale household financial distress. The problem is that the scale of this problem is only growing worse. The Central Bank recently reported that in October 2007 non-forint denominated household indebtedness once more accelerated, and in particular households were contracting these loans (using the home as security) for present consumption purposes (ie not for house purchases). Maintaining high domestic interest rates in this environment will only lead to more of this, and thus the problem will be even worse when the correction does eventually come.

Forward-rate agreements now indicate that investors have scaled back expectations for rate cuts during the next four months. The spread between the four-month forward rate and the base rate fell to 2 basis points from an average of 18 basis points in the past three months. A basis point is equivalent to 0.01 percentage point.

Hungary's inflation rate rose to 7.1 percent in November from 6.7 percent in October, rising for a second month. The increase was driven by food prices surging 11.6 percent in a year and the cost of household energy jumping 12.3 percent. Bank president Andras Simor also warned that forthcoming increases in regulated prices such as electricity could further derail disinflation.

With inflation at current levels, policy makers pledged to focus on ``cooling'' expectations to avert second-round effects. The bank said it will monitor wage negotiations between unions and corporate leaders as an indicator of expectations. Central bank representatives met with union and corporate leaders earlier this month to discuss the possible consequences of wage increases. Simor today said the central bank calculated with 7.7 percent private industry wage growth when preparing its latest inflation forecast. That corresponds to a wage agreement of about 6 percent, he added.

The central bank can't consider other economic policy objectives, even with growth at the slowest pace in 11 years, Simor said. Economic expansion in the third quarter was 0.9 percent from a year ago.

The bank feel that economic growth has probably "bottomed" but I am not so sure. In any event all are agreed that the rebound probably won't be quick, as domestic demand is unlikely to accelerate rapidly, and especially not with these tight interest rates. So the only question left is, how long can the central bank hold out against ever slower domestic demand in the face of a worsening external environment, which will make getting export growth no easy matter. Especially with strong internal inflation and the forint where it is now.