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QUARTERLY REPORT ON INFLATION MAY 2006

QUARTERLY REPORT ON INFLATION MAY 2006

MAGYAR NEMZETI BANKOn

MAGYAR NEMZETI BANKOn the one hand, the direct and indirect effects of the exchange rateappreciation following the widening of the band, and on the otherhand, the exchange rate level stabilising steadily on the strong side ofthe band may have played a significant role in the disinflation observablein Hungary since 2001. It is especially difficult to assess the second-rounddisinflation effect of exchange rate appreciation, whichworks through the adjustment of wages and expectations, and thedevelopment over time of these effects, since – in addition to theexchange rate – they may have been significantly influenced in the pastperiod by a number of factors (changes in the personal income tax andcontributions, modifications of minimum wages, a substantial pay risefor civil servants in 2002, etc.). 22The size of the pass-through for both a temporary and a permanentchange in the exchange rate may be modified by the stronger competitionfollowing the EU accession and due to the stable exchange rate.This has however an ambiguous effect: it may have reduced firms’market power, thus they are less able to ‘swallow’ the cost modifyingeffects of exchange rate fluctuations, which are especially influentialthrough imported raw materials and semi-finished products. Oneopposing, that is pass-through reducing, development might be if thefierce competition urges the corporations to follow a more aggressivemarket-procuring or market-defending strategy. In this case theywould try even harder to avoid changing their prices and to retaintheir customers by means other than price reduction – typically marketinginstruments.There are several uncertainties in assessing the effects of the currentexchange rate change (deprecation). On the one hand, monetary policymay have become more credible, which may have reduced the passthroughof temporary exchange rate movements. Inflation targetingproved essentially successful, as inflation was brought down close toprice stability, which probably adds to the credibility of the inflationtarget. Accordingly, any external, temporary shock, including theexchange rate shock, may ceteris paribus have a lesser impact oninflation.Finally, the increasing foreign exchange loan holdings of economicparticipants – mainly from the demand side – may also modify inflationaryeffects following from exchange rate changes: a weaker forintexchange rate entails a higher debt burden in forints, and thus maylead to lower demand through a decline in wealth and income.Although economic participants’ foreign exchange debts are growingrapidly, the current level is still relatively low. 24Accordingly, theeffect stemming from the revaluation of the foreign exchange debtmay first of all appear at the level of individual economic agents whoOn the other hand, the increased exchange rate volatility experienced inthe last six months can by itself modify – probably reduce – the magnitudeof the pass-through. The underlying reason for this is that due tohave a net foreign exchange debt, hence the decline in aggregatedemand, as compared to other inflanatory effects of the exchangerate, is probably very low at the moment.the higher volatility of the exchange rate, economic agents are less ableto assess whether an exchange rate change is lasting or temporary, andcompanies – in order to avoid costs related to changing their prices 23 –strive to avoid frequent price changes. Consequently, fewer participantsand to a lesser extent will react to a given change in the exchangerate. This factor, similarly to the former credibility factor, may onlymodify the pass-through stemming from a temporary change of theexchange rate, but not the effects a permanent change has on inflation.Overall, it can be established that the impact of the exchange rate oninflation is determined by several factors, which may also change astime progresses, and consequently, exchange rate pass-through mayalso change eventually. However, based on the currently availableinformation, there is not sufficient evidence to make us modify ourearlier assumption of the magnitude of the exchange rate passthrough.Over the longer run, inflationary and disinflationary factorsare expected to become more balanced, which may resultin inflation of around 3 per cent. With the slowdown in economicactivity, demand side pressure will weaken. On thecost side, we expect that as the primary effect of the rise inminimum wages tapers off, developments in unit labourcosts will be subdued. On the one hand, the reduction inthe social security contribution planned for 2007 allows forvery moderate developments in labour cost, and at thesame time, unit labour costs in the relatively loose labourmarket may change in line with price stability in the longerrun as well. In addition, the effect of high oil prices is alsomore likely to exert inflationary pressure in 2006 and in thefirst half of 2007, while in the longer term these effects willalso become weaker.In addition to the above, the slowdown in price dynamicsof items outside core inflation (unprocessed food, fuel22For a detailed analysis of wages and the labour market in general, as the main factors involved in long-term adjustment, see M. Zoltán Jakab and MihályAndrás Kovács ‘Factors in exchange rate pass-through: simulations using the NIGEM model’ (MNB Working Papers 2003/5).23Menu costs, information costs, possible costs stemming from loss of market.24See Charts 2-13 in the April 2006 issue of the MNB’s Report on Financial Stability.40QUARTERLY REPORT ON INFLATIONMAY 2006

INFLATION OUTLOOKprices) also has a reducing effect on the consumer priceindex over the longer run.Chart 3-1Core inflation developments*(annualised quarter-on-quarter changes)Per cent121086420-2-4Per cent1200 Q100 Q301 Q101 Q302 Q102 Q303 Q103 Q304 Q104 Q305 Q105 Q306 Q106 Q307 Q107 Q308 Q108 Q3* MNB estimate.Robust growth in all sectors over the short run andslowdown over the longer run is expectedIn our view of the real economy, robust external demandgrowth is coupled with accelerating investment and consumptionover the short run. As opposed to this, startingfrom 2007, most items of aggregate demand will continueto grow, but at a slower pace. Our expectations regardingboth external and domestic economic activities supportthis view. Over the longer run, from the external demandside, high oil prices and the adjustment of equilibriumproblems in the world economy may arrest growth, whichmay provide a basis for some slowdown in corporateinvestment and industrial activity.Chart 3-2The foreign and the domestic economic activityPer cent2520151050-500 Q101 Q102 Q103 Q104 Q1With the decline of the effect of the VAT rate cut and fiscaleasing, the expansion of households’ real income may slow05 Q1Value added, manufactoringForeign demand (based on imports)Export volume06 Q107 Q108 Q11086420-2-4Per cent2520151050-5down, also resulting in a lower consumption growth. At thesame time, household investment is expected to stagnateover the entire projection period. A slowdown in investmentdynamics over the longer run is also supported by theexpected deceleration of augmented government investment.Net exports may have a steadily positive contributionto GDP growth, although the depreciation of the realexchange rate will cause a relatively subdued growth surplusdue to the high import content of the economy. However, dueto a deterioration in the terms of trade, favourable processesin volume will not be directly reflected in value terms in thedevelopments of the external equilibrium.Chart 3-3ULC-based real exchange rate* and terms of trade(average of 2000=1)Per centPer cent1.051.000.950.900.850.800.7598 Q198 Q399 Q199 Q300 Q100 Q301 Q101 Q302 Q102 Q303 Q103 Q304 Q104 Q305 Q105 Q306 Q106 Q307 Q107 Q308 Q108 Q3ULC-based real exchange rate* Higher values denote depreciation.Terms of trade(right-hand scale)1.051.031.010.990.970.95Overall, in 2006, the gross domestic product will growfaster than potential output, at a pace of around 4.5 percent. Further on, GDP growth – and all its components –gradually slows down, stabilising at a rate of 4 per cent. ByChart 3-4Annual growth rate of gross domestic productand contributions to itPer cent-1 0123456789-2-3-4-5-61996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008Changes in inventories and stat. discrepancyNet exportsGross fixed capital formationPublic consumptionHousehold consumptionGDPPer centForecast-1 0123456789-2-3-4-5-6QUARTERLY REPORT ON INFLATIONMAY 2006 41

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