Hungary: Thoughts on Inflation Targeting Stephen Gilmore 19 th January 2007

1. Hungary: Thoughts on Inflation TargetingStephen Gilmore 19th January 2007

2. Earlier Disinflation Experiences were Instructive Interest Rates Follow Inflation Lower Source: Bloomberg The experience of countries like Italy showed that there were gains to be made by developing accurate inflation forecasts for both spot and implied forward interest rates.

3. The Same Lesson Applied in Hungary Interest Rates Follow Inflation Lower Source: Bloomberg If anything, interest rate declines in Hungary better anticipated future inflation declines, although there was some over-exuberance in late 2002 and early 2003.

4. Market Now Looking Through Transitory Effects Interest Rates Follow Inflation Lower Source: Bloomberg In 2003/4 rates tended to track headline inflation, whereas the relationship with tax-adjusted inflation has been better more recently.

5. Tight Monetary Conditions Assist Disinflation Currencies Tend to Outperform when Monetary Policy is Tight Among major currencies, high yielding currencies tend to appreciate in what is referred to as the “forward premium paradox”. In Hungary that effect is probably reinforced by Balassa-Samuelson and price convergence as well as MNB’s focus on the risk premium. The returns to being long HUF have been high. Source: Banque AIG

6. Forward HUF Rates Became a Focus Market Reflected Perceptions About EUR Adoption Source: Bloomberg

7. Credit Spreads also Came Down with Inflation Market Reflected Perceptions About EUR Adoption Meeting the Maastricht criteria was seen as credit positive. Euro adoption also added a non-zero probability of Euro-zone support. Early on, inflation was thought to be the binding Maastricht criterion. Source: Bloomberg

8. Exchange Rate Important Hungary had transitioned from a crawling peg, where the rate of crawl was eventually cut to zero; Hungary is a small, open economy; The exchange rate pass through was believed to be very high; The credit channel of the monetary transmission was considered weak; and The aim of policy was to adopt the Euro as quickly as possible and that meant transitioning to ERM II. That prompted the question of whether there was much to be gained from removing the exchange rate bands if it was only to be for a short period. Exchange Rate Chosen as Indirect Inflation Target

9. Inflation Followed the Exchange Rate Strong Link Between Exchange Rate And Inflation Note, though, that the relationship between the exchange rate and inflation appears to be changing – a theme we will come back to. Source: Bloomberg

10. Foreigners Attracted to HUF Assets Credible Exchange Rate Target Made High Yielding HUF Assets Attractive Non-resident holdings of Hungarian Government bonds, and their duration, increased sharply between mid-2002 and the latter part of 2003. Over the past few years Hungarian households have stepped up their foreign currency borrowing. Source: Bloomberg

11. Fiscal Cycle Complicates Matters Exchange Rate Target and Exchange Rate Bands are a Constraint The strong election cycle was even stronger than usual in 2001/2002 and posed particular problems for a monetary policy that was constrained by exchange rate bands. The fiscal boost and higher wages required a stronger than permissible exchange rate if the inflation target was to be met. Source: Bloomberg

12. Speculative Attack on the Exchange Rate In early 2003 there was an attack on the strong end of the band. More than EUR 5 billion in short term money flowed into Hungary in 2 days. The government would not contemplate a revaluation. Market participants learned or were reminded that: The exchange rate bands took priority over the inflation target. The government needed to agree to any change in the exchange rate bands. It is much easier to defend the strong end of the band than the weak end and that the costs of challenging the band could be sizable. MNB learned that: It pays to keep the currency away from the very strong end of the band. Exchange Rate Bands Take Precedence Over Inflation Target

13. Realignment of Central Parity In June 2003, the forint’s central parity was devalued by 2.26%. The currency weakened sharply. MNB hiked by 600bp over the next 6 months. By the end of the year MNB had stopped announcing its exchange rate target. MNB and the Government were reminded that: They should be very careful in adjusting the nominal anchor. The exchange rate arrangement was a straightjacket. Market Participants were reminded that: The Monetary Council was prepared to hike aggressively when needed. Market Very Sensitive to Changes in Exchange Rate Target

14. FX Moves Have Been Relatively Large over Last 12 Months Exchange Rate Has Become Relatively Less Important Source: Bloomberg

15. More Lessons on Exchange Rate • The currency volatility and weakness coming into the 2006 elections provided another set of lessons. • The Monetary Council’s reaction to a weaker currency was far more muted than had been the case in 2003: • smaller inflation pass-through; • Euro adoption date pushed back to some undefined time; • Monetary Council composition change. • Government comments on the exchange rate can matter. • The external background reinforced the domestic factors. Exchange Rate Has Become Relatively Less Important

16. Other Observations The Inflation Report is valuable for market participants. The continuing improvement in the transparency of the Monetary Council is welcome. The move to a continuous, medium term point target for inflation serves to reinforce the credibility of the target, especially given the uncertainty over the possible timing for Euro adoption. The reduced emphasis on the exchange rate lessens the potential conflicts between monetary and fiscal policy, even if the maintenance of exchange rate bands still poses some potential dilemmas. Exchange Rate Has Become Relatively Less Important

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