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QUARTERLY REPORT ON INFLATION MAY 2006

QUARTERLY REPORT ON INFLATION MAY 2006

INFLATION OUTLOOKIn our projection, the growth rate of the consumer price indexaccelerates from 2 per cent in 2006 to around 3 per cent in2007 and 2008. In parallel with this, the core inflation indicatormay also increase from the present very low level of 1 percent to about 3 per cent. We expect this to materialisethrough a gradual acceleration of inflation of products in foreigntrade, while in the services sector the rate of increase inprices may sink from the current level to around 4–5 per cent.Box 3-1 AssumptionsIn line with our earlier practice, our forecast is conditional, i.e. basedon the assumption of fixed paths for certain variables. In accordancewith our rules, exchange rate data were fixed at the average of the lastfull month for the entire projection period. Accordingly, the calculationsare based on a EUR/HUF exchange rate of 265.3 and aaround 0.8 per cent of GDP. An approximately one half percentagepoint improvement of the primary balance is assumed for 2007 and2008. As measures already in place and budgetary determinationswould project a 1-1.5 percentage point worsening of the deficit upuntil 2008 (without further steps), the moderate fiscal contractionassumed in the forecast would require measures exceeding two percent of GDP to be taken by 2008.EUR/USD rate of 1.227. In addition, the forward path was taken intoaccount for the price of the Brent oil, which is hovering around USD70 per barrel, following a slight increase. We also assumed a 6 per centcentral bank base rate and 6.8 per cent five-year bond yield.Finally, the two fan charts provide information on the uncertainty ofour projection stemming from the difference between the aforementionedvariables and internal mechanisms of the economy (except forthe interest rate as a monetary policy instrument and the exchangeOur forecast for 2006 is based on the measures planned in the tax lawand measures specified so far, which resulted in a total fiscal easing ofrate). The Report is based on information available by 15 May, at theclose of the business day.Trend inflation stood between 1 and 2 per cent in 2006 Q1,but by the second part of the year core inflation is expectedto increase as a result of numerous external and internaldevelopments. In the later phase of our projection periodthese effects will gradually decline, and trend inflation maysettle at around 3 per cent in 2008.In the short term, most factors suggest an increase in inflation.Imported inflationary pressure is expected to graduallystrengthen due to the weaker HUF, the effect of market competitioncoming to an end, an increase in European industrialgoods inflation and rising oil prices. In addition, a greatpart of domestic developments will also have an inflationaryeffect: the rise in minimum wages this year and buoyant economicactivity point to an increase in prices. At the sametime, decelerating inflation in market services and declininginflation expectations may partly contribute to offsetting theabove factors.Box 3-2 Uncertainties surrounding theinflationary effects of changes in theexchange rateThe impact of changes in the exchange rate on the domestic consumerprice index is characterised by the magnitude of exchange rate passthrough.Changes in the exchange rate affect inflation through severalchannels and over different time horizons. Although the extent anddevelopments over time of the exchange rate pass-through are of keyimportance in terms of meeting the inflation target, quantification ofthe contributions of the individual effects, which change over time aswell, entails significant uncertainties. Following an outline of individualchannels, difficulties arising in the analysis of the current situationIt is mainly the direct inflation effect stemming from the changes indomestic prices of imported consumer goods which first prevails inthe event of forint weakening. Over a medium term horizon (one ortwo years), price changes of imported goods as cost elements used inproduction and also the price changes of goods competing withimported products, but produced in Hungary affect inflation. Thislatter effect develops as a result of the demand regrouping betweenimported and domestic products and the resulting changes in profitof domestic producers. 20 Over the longer run (three to four years),effects appearing through changes in wages and labour marketdevelopments in general and due to the modification of expectations,which also facilitate wage adjustment, may prevail. 21in Hungary are presented below.20For example, in the case of depreciation, imported goods become, ceteris paribus, relatively more expensive compared to the goods produced byHungarian producers competing with these products. Consequently, demand for goods made in Hungary increases, and, as a response, Hungarian producersraise their prices, which results in an increase in their profits. An effect contrary to the above is that the real value of incomes declines as a resultof the increase in the price level, which, through the decline in aggregate demand, tempers the price increase stemming from the depreciation.21The effects of exchange rate changes on real-economy and nominal variables are discussed in detail in the MNB’s BS 2005/6 Background Study.QUARTERLY REPORT ON INFLATIONMAY 2006 39

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