Inflation Targeting in Hungary: Lessons from the first 5 years

István Hameczdirector

Magyar Nemzeti BankEconomics and Monetary Policy Directorate

19th January, 2007

Outline• Why IT in Hungary?• Key elements of the Hungarian IT experience

– Goal(s)

– Independence

– Transmission

– Transparency

– Forecasting ability

• Performance

Was IT the appropriate choice for Hungary in 2001?

Traditionally (up to 2001) tight exchange rate management, with external balance strongly in focus

• 2000-01: rate of crawl close to zero, inflation stuck at 10% level

• Need to shift to a new regime• 2 viable alternatives: IT or currency board (CB)No in-between solutions, as• Capital flows fully liberalised (EU)• Large domestic currency denominated public debt• Financial markets relatively open even before full

liberalisation strong exposure to risk premium shocks low chance for the survival of a narrow-band fixed

regime

Advantages of IT vs CB• More flexible – same shocks may cause smaller output

fluctuations than in CB

• If fiscal and premium shocks are substantial, CB credibility may not be 100%

• Costs of a CB failure may be more severe than missing a few inflation targets

• Timing of meeting the inflation criterion more difficult in CB (see Lithuania)

• Not really an option after EU-entry (opposition from EU)

IT vs ERM2 as alternative roads to the euro

CEE economies ultimately have to introduce the euro, but • Length of the run-up period uncertain• Fiscal discipline not strongly established fiscal

shocks trigger postponements of euroERM2 is in between the corner solutions of IT and CB• As such, not a good choice for the long (or indefinite) –

term• Credibility loss of an ERM2 failure especially large Revealed preference in larger CEE countries: do IT as

long as possible, minimise ERM2 period

How to do IT properly?IT (if properly done) is a good monetary regime for

the run-up period

Key ingredients for a succesful IT:• Clear mandate (≈ non-conflicting goals)• Independence• Effective transmission• Forecasting ability• Transparency

IT + a (wide) ER band?Legal mandate is clear: the primary goal is price stabilityBut, in practice, ER band introduces another goal

Historical background:

• 2001: Hungary gave up a narrow-band crawling peg and introduced a +/-15% band in which the HUF would float freely

• IT only after a couple of months, to provide a nominal anchor • fiscal policy was on track, fast EU, ERM2 and eurozone entry

was envisaged• it seemed odd to switch to free float for only a short period

before ERM2

IT + a (wide) ER band? (2)What happened in fact:

• due to recurring fiscal slippages, the euro entry date was postponed indefinitely

• on a long horizon the two goals are bound to conflict• this took place as early as in 2003, in the form of a speculative

attack against the strong edge

As to the future… • any decision about the band is a joint responsibility of MNB

and government • until then, IT in Hungary remains somewhat constrained

Independence

• Formally OK, but market perception of independence suffered some blows

• Continuous pressure from government to ease policy (weaker ER)

• Usual wording: „more cooperation” is needed in fiscal and monetary policy

• But difficult to „cooperate” with an expanding fiscal policy• Against this background, it came as a big shock to the market

when the MNB agreed to devalue the central parity – risk premia increased substantially

• The government initiative to enlarge the Monetary Council by 4 new members did not help either, although ex post it does not seem to have changed policy significantly

Efficiency of Transmission

• A recent volume „Monetary Transmission in Hungary” (2006) summarizes our knowledge

• Using econometric techniques we could demonstrate the efficiency of monetary policy, particularly in the short run (1 year in the case of inflation)

• The dominance of the exchange rate channel is a key feature of Hungarian monetary transmission

• The relative weakness of the interest rate channel will disappear after euro adoption as it will include what is now classified as foreign demand channel as well

Transparency

Continuous tendency in improving transaprencyStarted with forecasts:• Inflation forecasts, conditions, model descriptions, etc.Then continued in policymaking:• Pre-announced rate-setting dates, press conferences,

minutes, voting record• The latter tendency largely parallel with the MC shifting

from ’collegial’ to ’individual’ Special feature: decision to publish Bank fiscal forecasts in

inflation reports Caused a lot conflict with government, but this ’fiscal

whistleblowing’ paid off in terms of credibility

Forecasting ability

Continuous development of the forecasting toolbox• Partial models + expert forecasts at the beginning• Quarterly Forecasting Model (large-size, estimated,

New-Keynesian) from 2003 onwards• Final forecast: model + expert infoForecast track record: • good performance after controlling for conditionality• successful in capturing turning points, • generally gave right policy signals in time

IT performance Achievements:

• Succesful in breaking the inflation inertia of 2000-2001 and bringing down inflation to single-digit level

• Achieved this without a sizeable output loss• Some one-off inflationary shocks (VAT increases) were

accomodated, but second-round effects remained modest

Question marks:

• Global disinflation and the price effect of EU accession may have contributed as well

• Wage inflation still not anchored convincingly

Thank you for your attention!

From tight ER management to a wide band: HUF/basket 1994-2007

4,7

4,8

4,9

5,0

5,1

5,2

5,3

5,4

5,5

5,6

5,7

5,8

jan.9

4jú

l.94

jan.9

5jú

l.95

jan.9

6jú

l.96

jan.9

7jú

l.97

jan.9

8jú

l.98

jan.9

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l.99

jan.0

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jan.0

1jú

l.01

jan.0

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l.02

jan.0

3jú

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jan.0

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l.06

jan.0

7

Loga

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bas

ket (inve

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4,7

4,8

4,9

5,0

5,1

5,2

5,3

5,4

5,5

5,6

5,7

5,8

Foreign holdings of HUF T-bonds as % of total HUF T-bonds

20

25

30

35

40

45

50

55

1999

.05.

31

1999

.11.

30

2000

.05.

31

2000

.11.

30

2001

.05.

31

2001

.11.

30

2002

.05.

31

2002

.11.

30

2003

.05.

31

2003

.11.

30

2004

.05.

31

2004

.11.

30

2005

.05.

31

2005

.11.

30

2006

.05.

31

2006

.11.

30

%

5x5 FRA spread (basispoints)

0

50

100

150

200

250

300

2003

.01.

02

2003

.03.

02

2003

.05.

02

2003

.07.

02

2003

.09.

02

2003

.11.

02

2004

.01.

02

2004

.03.

02

2004

.05.

02

2004

.07.

02

2004

.09.

02

2004

.11.

02

2005

.01.

02

2005

.03.

02

2005

.05.

02

2005

.07.

02

2005

.09.

02

2005

.11.

02

2006

.01.

02

2006

.03.

02

2006

.05.

02

2006

.07.

02

2006

.09.

02

2006

.11.

02

Forecast performance

Headline CPI

ForecastTax-adjusted

CPI

0

2

4

6

8

10

12

1q01

2q01

3q01

4q01

1q02

2q02

3q02

4q02

1q03

2q03

3q03

4q03

1q04

2q04

3q04

4q04

1q05

2q05

3q05

4q05

1q06

2q06

%

IT performance (1)

0

2

4

6

8

10

12

Jan

/ 20

01

May

/

Sep

/ 20

01

Jan

/ 20

02

May

/

Sep

/ 20

02

Jan

/ 20

03

May

/

Sep

/ 20

03

Jan

/ 20

04

May

/

Sep

/ 20

04

Jan

/ 20

05

May

/

Sep

/ 20

05

Jan

/ 20

06

May

/

Sep

/ 20

06

%

0

2

4

6

8

10

12 %

Tax-adjusted CPI Headline CPI

IT performance (2)GDP growth - annualized q/q growth

0

1

2

3

4

5

6

7

8

1997Q

1

1997Q

3

1998Q

1

1998Q

3

1999Q

1

1999Q

3

2000Q

1

2000Q

3

2001Q

1

2001Q

3

2002Q

1

2002Q

3

2003Q

1

2003Q

3

2004Q

1

2004Q

3

2005Q

1

2005Q

3

2006Q

1

%

Actual GDP Potential GDP