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MAGYAR NEMZETI BANKThe distortion is presumably more serious among market servicescompanies than in manufacturing. It is also mainly the services sector,and within that the branch comprising companies dealing withfinancial activities, which is responsible for the outstanding wageChart 2-22Kaitz indices?*inflation of 2006 Q1. Still assuming that a high percentage of the sector’ssignificant wage inflation in Q1 is merely a statistical phenomenon,the impact of the rise in minimum wages on the aggregate wageinflation is also proportionately lower than what is indicated in thelabour time series.Earlier studies confirm that although the magnitude of the first rise inminimum wages in 2001 was greater than that of the rise in 2002, thefirst labour market intervention was less effective. 8 This anticipationof ours is confirmed by the chronological and cross-sectional (intercountry)comparison of the ratio of minimum wages to average earnings(so-called Kaitz indices). 9Chart 2-22 reveals that following the52504846444240383634323028max EU25 in 2004 (Ireland)average EU25 in 2004min EU25 in 2004 (Estonia)5250484644424038363432302819931994199519961997199819992000200120022003200420052006rise in 2001 the index increased from 30.5 per cent, which is very lowin international comparison (the lowest among the current 25 MemberStates of the European Union), to 41 per cent, which is close to theEuropean average. The rise in 2002 already added to a much higherKaitz index, thus it can be assumed that the actual number of thoseconcerned was also higher. Based on the chart we can come to anapproximate conclusion regarding the aggregate effects of the rise in* The quotient of the prevailing minimum wage and the wholeeconomyaverage earning in Q1 of the given year. As an alternativeindicator, the ratio of the minimum wage in the given year tothe average earning of the previous year and of the last quarterof the previous year was also calculated. Developments in time ofthe index are similar in the latter cases as well.** The 2006 Q1 earnings data are actual up to February, while theMarch data point was estimated using statistical methods.minimum wages in 2006 compared to the rise in 2001 and 2002. Afterthe current rise the Kaitz index is still expected to be lower than thevalue for 2001, i.e. the actual wage shock will probably be lower thanin 2001. However, as in the starting year of 2005 the ratio of the minimumwage to the average wage may be much higher than in 2000 andlower than in 2001, the effectiveness of the impact of the rise (i.e. theratio of actual increase to the wage increase published by the CSO) willprobably be between that of 2001 and 2002.can be assumed that due to the higher minimum wage level of 2005 andthe recommendations concerning those with higher education, thisyear’s rise may trigger more significant labour market developmentscompared to the previous two labour market interventions. On theother hand, this year’s rise was carried out in a looser labour marketenvironment compared to previous years and amongst better growthprospects, and these factors may mitigate the negative impact of theintervention. It can also be assumed that the gradual abolition of theAs was the case with the impact of rises in the minimum wages in earlieryears, there is a lack of consensus among Hungarian economistsregarding the expected effects of the rise in 2006. On the one hand, ithealth contribution paid by employers and the reduction of the socialsecurity contribution envisaged for 2007 may somewhat offset thisyear’s wage cost increase of firms. 108See e.g. G. Kertesi–J. Köllõ (2004): The employment consequences of the 2001 rise in the minimum wage (A 2001. évi minimálbér-emelés foglalkoztatásikövetkezményei), Economic Review (Közgazdasági Szemle), Volume LI, April 2004, pp. 293-324.9Of course, the index does not take account of wage dispersion – and in particular the actual wage dispersion – and its possible change, thus we can estimatethe number of those concerned only in an indicative manner.10See details of Hungarian and international experiences in rises in minimum wages and the expected effects of this year's rise: Dóra Benedek et al.:Increases in the minimum wage in Hungary, 2001-2006 (Minimálbér-emelések Magyarországon 2001–2006), Working Papers published by the Ministryof Finance (PM Kutatási Füzetek), No. 16.30QUARTERLY REPORT ON INFLATIONMAY 2006

2.3. Inflation developmentsSince the previous Report, the consumer price index(CPI) has continued to decline: it stood at 3.3 per centin 2005 Q4 and 2.5 per cent in 2006 Q1, and thus theinflation target of 4 +/-1 per cent for the end of last yearwas met. Disinflation was reflected in the fall in coreinflation as well: annual indices of core inflation amountedto 1.3 and 0.6 per cent in these two quarters, respectively.11The primary underlying reason for the disinflationobserved early this year was the reduction of the highestVAT rate from 25 per cent to 20 per cent, which coveredalmost all industrial products and nearly half of marketservices. As we can only estimate the extent of theappearance of the VAT rate cut in consumer prices, at thebeginning of the year the assessment of trend inflationdevelopments – which do not contain the one-off VATChart 2-23CPI and core inflation(year-on-year indices)Per cent12108642001 Q101 Q201 Q301 Q402 Q102 Q202 Q302 Q403 Q103 Q203 Q303 Q404 Q104 Q204 Q304 Q405 Q105 Q205 Q305 Q406 Q1Core inflationPer cent12Consumer price indexeffect and show lasting inflation trends – became moreuncertain than usual.1086420Box 2-3 To what extent is the VATrate cut reflected in consumer prices?Our analyses suggest that the critical part of the primary effect of theVAT rate cut took place in the first two months of the year. Earlier wehad estimated the total primary price level reducing effect of theOctober 2005 and January 2006 VAT rate cuts as 1.4 percentage12, 13points. However, as evidenced by available data, the price levelreducing effect may be around 1.0 percentage point only, i.e. approximately0.4 percentage points lower than previously estimated. 14Our product group level analyses suggest that in our earlier calculationsthe effect of the VAT rate cut was mainly overestimated with regard toindustrial products. However, the underlying reason is not yet clear. Wemay have misjudged the existing product market factors of the priceeffects of the VAT changes, i.e. the price elasticity of demand and supplyand price transparency. In this case, the lower than estimated decline inprices at the beginning of the year does not necessarily influence thelonger-term inflation outlook. However, it is also possible that the previousupward trend in product market competition slowed more thanexpected, which, in turn, may also affect future developments in inflation.11The consumer price index in April 2006 stood at 2.3 percent, while core inflation was 0.7 percent. The April figures reinforce our assessment about therecent inflationary trends.12We had estimated the technical effect as 1.9 percentage points, which was later confirmed by CSO figures.13In our estimates for the aggregate effect of the VAT rate cut we did not take into account the VAT rate cut of alcoholic drinks, tobacco products and motorvehicles, as in case of these products the VAT rate cut was offset by the increase in the excise tax and registration tax, respectively. It is worth mentioningthat the price of wine increased as of January, despite the fact that in case of this product the VAT rate cut was not offset by raising the excise tax,moreover, the latter was abolished completely.14It is difficult to assess the effect of the VAT rate cut on the price level not only looking ahead, but also looking back. The problem is that regarding theprice time series of a given group of products, trend inflation process cannot clearly be separated from the effect of the VAT rate cut. One of the possibilitiesis to estimate the trend inflation process using some kind of a model (e.g. ARIMA), and identify the effect of the VAT rate cut as the differencebetween the price change obtained from the model and the actual developments in prices. Another possibility is to create a reference time series of theproducts not affected by the VAT rate cut which showed similar price dynamics to that of the product group examined. In this case, one can assume thatthe difference between the price developments of the ranges of products affected by the VAT rate cut and not affected by the VAT rate cut was causedby the VAT rate cut. In this case, this method could be applied for market services. Finally, useful information can be gained from the distribution of monthlyprice changes of individual products. Based on the distributions it can be seen whether the effect of the VAT rate cut affected individual product groupsevenly (single-mode or multi-mode distribution), and how many months it takes for the VAT rate cut to have an effect, i.e. whether at a given point in timethe distribution of price changes which was usual before the VAT change has been more or less restored.QUARTERLY REPORT ON INFLATIONMAY 2006 31

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