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QUARTERLY REPORT ON INFLATION MAY 2006

QUARTERLY REPORT ON INFLATION MAY 2006

MAGYAR NEMZETI

MAGYAR NEMZETI BANKcontrast, given the worsening of the terms of trade over theshort run, gross domestic income will increase substantiallyslower than GDP in this year, at a pace of around 2.5 percent. Starting next year however, it gradually acceleratesto a growth rate of 3.5 per cent, nearly on par with GDPgrowth.Rise in minimum wages is expected to temporarilyadd to wage inflationIn the labour market, substitution of labour with capital isexpected to continue both at the corporate level and due tothe gradual decline in sectors which employ relatively morelabour. The increase in minimum wages may facilitate thisprocess, although we believe that the slowdown in wageswill probably break only temporarily. On the one hand, therise in minimum wages does not completely translate into areal rise in wages. On the other hand, in the loose labourmarket at an aggregate level the feed-through effects of thewage shock are much less likely to be felt compared to therises in 2001 and 2002. Thirdly, the reduction of the socialsecurity contributions planned for 2007 may be a significantlabour cost reducing factor, which also counters the feedthrougheffects of the rise in minimum wages. Overall,wages in the private sector may increase by around 8 percent in 2006, and by 6–7 per cent over the longer run.Accelerating inflation in the short run, morebalanced core inflation in the long runFollowing the earlier, favourable disinflationary effects,external factors determining inflation will trigger an accelerationof trend inflation. The inflation reducing effect of theincreasing competition after EU accession has weakenedChart 3-5Euro area industrial goods price indices(annual changes)1.61.41.21.00.80.60.40.20.0Per cent96 Q196 Q397 Q197 Q398 Q198 Q399 Q199 Q300 Q100 Q301 Q101 Q302 Q102 Q303 Q103 Q304 Q104 Q305 Q105 Q306 Q1Consumer price ofindustrial goodsPer cent76543210-1-2-3-4Producer price of industrialgoods (right-hand scale)in the past period, while the euro area consumer priceindex of industrial products has started to rise after a longperiod of stagnation. In addition to accelerating importedinflation, the HUF exchange rate, which is now more than 5per cent weaker than it was previously, may also causehigher inflation, especially in the area of industrial goods.Inflationary pressure is also increased by the historicallyhigh price of oil, although it is very difficult to assess itsimpact. In addition to its tangible effect in vehicle fuel andenergy prices, other countries also report an only subduedpass-through. 25 The appearance of the oil price increase inconsumer prices may be hindered by strong competition,or even if the high prices are justified by the increaseddemand for oil. In our projection our calculations are basedon a modest price increase in line with the forward pathand on its primary effects mainly. Therefore, oil prices,which are currently hovering at historical highs, will add toinflation only at the beginning of the projection period,while over the longer run oil prices will mainly influenceregulated energy prices. Accordingly, as far as regulatedprices are concerned, energy prices are expected to graduallyadjust to high oil prices, while developments in mostof the remaining items are assumed to be neutral, i.e. theyare presumed to follow core inflation.This year, in addition to the aforementioned factors, robustexternal and domestic economic activity will also entail anincrease in inflation, although over the longer run a slowdownin economic activity is expected to be coupled witha decline in demand side inflationary pressure.Over the longer run, expenditure side inflationary pressuremay also weaken, as most expenditure side factors, suchas labour costs, exchange rate and the effect of oil prices,are expected to peak in a year, provided that our assumptionsin the main scenario hold true.As a result of the processes outlined above, the significantinflation differential between the prices of the servicessector and of industrial products observed in the pastperiod is expected to decline over the forecast period. Onthe one hand, the underlying reason is that all factorspoint to an increase in prices of industrial goods, while onthe other hand, more marked disinflation in market servicesis expected, in which lower inflation expectations anddeclining labour costs due to expected measures mayalso play a role.At the beginning of our projection period, the impact of earlierdisinflationary effects and the proliferation of inflation-25See e.g. the IMF's spring 2006 publication titled World Economic Outlook and the March 2006 Monthly Bulletin of the ECB.42QUARTERLY REPORT ON INFLATIONMAY 2006

INFLATION OUTLOOKary factors on price indices is masked by the VAT rate cutin 2006; thus core inflation in 2006 is expected to slightlyexceed 1 per cent, while later it is expected to be around3 per cent.Consumer price index to exceed core inflation inthe beginningDue to the double-digit unprocessed food inflationobserved at the beginning of the year and increasingpetrol prices resulting from the oil price rise, the consumerprice index is expected to significantly exceed core inflationand reach around two per cent in 2006. Over thelonger run, however, with the decline in food prices and theweakening of the effect of the oil price rise, the growth rateof the consumer price index will be essentially identicalwith that of core inflation.Chart 3-6Annual growth rate of the consumer price indexand individual sectors’ contributionPer cent1210864202000 2001 2002 2003 2004 2005 2006 2007 2008Core inflationRegulated pricesConsumer price indexForecastBalanced uncertainty surrounding the consumerprice index, growth is burdened with a slightlydownside riskPer cent12Unprocessed foodFuel and market energyWe believe that uncertainties surrounding the main scenarioof our inflation projection are broadly balanced overthe entire forecast horizon. This is also reflected by the fanchart, which indicates a somewhat higher probability ofinflation exceeding the target in 2007, while in 2008 theuncertainty surrounding the inflation target is nearly symmetrical.With regard to the uncertainty dispersion aroundeconomic growth, slight downside risks are perceived overthe entire projection horizon.The balanced risk assessment around our inflation forecastis the result of upside and downside risks, which more orless offset one another. The most important risk factor suggestinglower inflation is the reduction of the social securitycontribution. We believe that one cannot rule out the1086420possibility that an improvement in profitability due to thereduction of the social security contribution will entail higheremployment, lower wage inflation and lower inflationcompared to the main scenario.A stronger-than-assumed demand tightening effect of thebudget also represents a risk pointing to lower inflation.One can also not rule out that favourable developments inmarket services prices mirror a slowdown in inflationexpectations, which may also lead to lower inflation.Chart 3-7Inflation fan chart*(percentage changes on a year earlier)Per cent876543210-104 Q104 Q305 Q105 Q306 Q106 Q307 Q107 Q308 Q1Per cent* The fan chart represents the uncertainty around the central projection.Overall, the coloured area represents a 90 per cent probability. The central,darkest area containing the central projection for the consumer price indexillustrated by the white dotted line (as the mode of distribution) refers to 30per cent of the probability. The year-end points and the continuous, horizontalline from 2007 show the value of the announced inflation targets.Chart 3-8GDP projection fan chart*(percentage changes on a year earlier)Per cent654321008 Q3Per cent04 Q104 Q204 Q304 Q405 Q105 Q205 Q305 Q406 Q106 Q206 Q306 Q407 Q107 Q207 Q307 Q408 Q108 Q208 Q308 Q4* The fan chart represents the uncertainty around the central projection.Overall, the coloured area represents a 90 per cent probability. The central,darkest area containing the central projection for GDP illustrated by thewhite dotted line (as the mode of distribution) refers to 30 per cent of theprobability.876543210-16543210QUARTERLY REPORT ON INFLATIONMAY 2006 43

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