The Hungarian central bank played a master stroke in March, lowering inflation forecasts sharply and cutting rates in response to inflation surprises having overtaken it over the past quarter. An analysis of Commerzbank.

Having earlier signalled that further monetary easing would be done mainly using unconventional tools, it would have been only too easy for the National Bank (MNB) to have got “stuck in”’ with such a view – instead, the bank changed its signalling quite quickly, and then followed up with actual rate cuts even before the consensus had fully appreciated that rate cuts were coming – this will likely also boost the efficacy of the policy.
But, crucially, the MNB averted falling seriously behind the curve. We don’t always see central banks reacting this promptly.
MNB lowered its base rate by 15bp from 1.35% to 1.2%, lowered the deposit rate on its overnight deposits to -0.05%, and cut the interest rate on its overnight collateralised loan facility from 75bps above base rate to 25bps above base rate – in effect lowering the upper limit of its rate corridor from 2.1% to 1.45%. These moves will have an immediate impact of lowering market interest rates across the spectrum.
The negative deposit rate, in particular, is a response to the European Central Bank’s (ECB) recent depo rate cut. MNB does not want the forint to strengthen from short-term intra-European Union capital inflows.
MNB backed the moves by sharply cutting its 2016 consumer price index forecast from 1.7% to 0.3% and the 2017 forecast from 2.6% to 2.4%. The bank now does not anticipate meeting the inflation target before well into 2018.
Why did MNB make these changes? The underlying rationale had been building up for some time: the bank has had to continually revise lower its 2016 inflation forecast. Even after such revisions, the risks are to the downside: inflation surprises, calculated using consensus expectations, have been significantly negative even in recent months.
In its recent report “Hungary – Why we expect further monetary easing”, Commerzbank laid down the factors that we thought would prompt MNB to resume cutting rates. Among these were three main arguments, besides just the low inflation argument: 1) Growth is likely to decelerate, 2) MNB’s quantitative easing (QE) may not depress yields by as much as imagined, and 3) MNB would not want its rate differential versus the ECB to widen out.

What is MNB catching up to?

On the major elements of the macroeconomic outlook, the MNB is very optimistic about domestic demand and has, in fact, raised its 2016 gross domestic product growth forecast from 2.5% to 2.8%; we are more conservative with our 2.2% forecast.
This difference arises because of our sub-consensus forecast for the German economy, where we continue to see risks from global demand softening. Secondly, EU fund inflows, which had contributed significantly to Hungarian growth last year, will pause this year. We also note that consumer confidence has stopped improving in Hungary.
Nevertheless, this is not an area of serious divergence of opinion: MNB appears to have taken on board that stable demand and wage growth are not passing on to broader inflation in today’s world. MNB has let go of the “textbook view” that “stable domestic demand will gradually bring inflation back to target”, and is instead focusing on the hard data on inflation and foreign exchange trends.
The second macroeconomic pillar, of course, is inflation: we assume that MNB has lowered it commensurately too, perhaps to 2% from 2.4%. It would take serious upward inflation dynamic for the core inflation rate, which is running at 1.5%, to accelerate and average 2% for 2016, let alone 2.4%.
In fact, the steady downward revisions MNB has had to make to this forecast over the past year tell a broader story about low headline inflation seeping through to core categories. MNB’s language appeared to fully take this on board when it did not pin the entire forecast change on temporary commodity price effects.
Finally, MNB could have held on to rates and opted just to expand the size of its QE tenders, which would be consistent with its earlier “promise” to use QE as the main policy tool. But the QE operations have had only a mild effect on Hungary’s yield curve. This is not immediately obvious because the slope of the local bond curve has been stable after all.
Nevertheless, when comparing with a peer such as Poland, which is not operating long-end yield capping QE, the added advantage for Hungary is difficult to see. Hungary did outperform Poland for much of Q1 2016, but that was because of the Polish curve steeping on idiosyncratic political risk.
Hence, interest rate swap tenders have not been a compelling substitute for base rate cuts, especially when the base rate itself is still high by regional standards. If the base rate has to drop to zero over the coming year, QE will anyway have to take over – but there is not much rationale to use the tools in reverse order.

Policy conclusions

We expect MNB to cut the base rate again by 15bp in April, taking it to 1.05%. Our year-end forecast for the rate is 1% but the risk is clearly to the downside. We will revisit our forecast soon. We do not rule out the base rate declining even to zero, but this would be contingent upon further ECB easing and negative interest rates adopted by peers such as the Czech Republic, which cannot yet be taken for granted.
In conclusion, this latest move by MNB was pro-active rather than reactive. True, the ECB had eased recently. But neither had the forint strengthened too much since then, nor was it so obvious that the old story of inflation gradually returning to target on its own had become untenable – there was no “market pressure” for MNB to urgently break its status quo.
Rather the MNB was beginning to fall behind with its policy relative to inflation surprises but has caught up with one sharp move.

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