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Are we Entering a ‘New Era’ in Monetary Policy?

Analysis

At its latest rate-setting meeting on June 18, the central bank reduced the key interest rate in line with expectations but to a lesser extent than before. With this last cut, the interest rate reduction cycle that started in May of last year may have come to an end.

As expected, the National Bank of Hungary (MNB) lowered its key interest rate by 25 basis points to 7% at its rate-setting meeting on June 18. The move aligned with expectations; market experts almost unanimously expected that the central bank would slow from the usual 0.5 basis points rate cuts seen in recent months.

No further cuts are expected from July. However, a few weeks ago, it seemed more likely that the final cut of 50 basis points would be in June and that in the second half of the year, the MNB would only make occasional cuts.

The current decision is not solely based on the development of inflation, since in May, although the consumer price index rose from 3.8% to 4%,

the rate of annual price increase was still lower than expected. But in the meantime, the financial market situation has become turbulent again. The most notable part of this was the weakening of the forint.

The international environment has become less favorable overall in the last month. The U.S. Federal Reserve once again became more pessimistic about inflationary processes, making the interest rate path more uncertain in the United States.

Meanwhile, the perception of the European economy worsened due, among other things, to the fact that the European Parliament elections caused domestic political uncertainty in several large member states. These factors also affect the interest rate policy of emerging countries, as investors have become more risk-averse. Market analysts also confirmed this.

“The development of the international financial market environment may have played the biggest role in the slowdown; the central bank also emphasized in the announcement that the willingness to take risks has deteriorated,” Makronóm’s senior analyst Dániel Molnár said in a press release.

Strict Communication

Although the European Central Bank had started easing interest rates at its June meeting, at the same time, its communication had been quite strict, which heralds a cautious, smaller-scale continuation of the interest rate reduction cycle, he added.

“Meanwhile, interest rate expectations related to the Fed shifted higher. The U.S. labor market remains strong, while inflation data also suggests that the price increase has not yet been fully suppressed in the world’s largest economy. For this reason, instead of the previously expected three interest rate cuts this year, the Fed’s decision-makers are now predicting one, or in favorable cases, two interest rate cuts. Higher U.S. yields limit the central bank’s room for maneuver, both in the case of the ECB and in emerging markets,” Molnár explained.

The MNB announced that starting in July, the central bank will have substantially less maneuvering room to reduce the base rate. Some parts of the last paragraph of the announcement were changed, the expected interest policy of the major central banks was highlighted, and a further reduction of the base rate was omitted from the last sentence, as Equilor analysts emphasized in their reaction to the decision.

Those analysts also noted that MNB Deputy Governor Barnabás Virág had, once again, presented those risks to which special attention would be paid at the next rate-setting meetings.

“Among the global risks, he singled out the deterioration of international investor sentiment and the rise in volatility following the EP election. Meanwhile, the external interest rate environment may remain high for a prolonged period. Regarding domestic inflation, he mentioned the expected increase in core inflation and strong inflation expectations. Possible inflationary risks of strong wage dynamics are also monitored. In addition, he mentioned the importance of achieving the set budget deficit targets in a disciplined manner,” they wrote.

Changed Guidelines

As for the future, analysts expect some further drop in the key rate by the end of the year; however, the central bank’s guidelines have clearly changed.

“According to our expectations, the central bank’s interest rate reduction can only continue at a slower pace in the coming months, and monetary steps will not necessarily take place at every meeting. In addition, much more attention will be paid to the international financial markets,” Makronóm’s Molnár said.

“The bottleneck in this regard may be the Federal Reserve’s monetary policy. According to our expectations, the interest rate reduction in the [U.S.] economy could begin as early as September, which would also expand the Hungarian central bank’s room for maneuver. Overall, we expect the Hungarian base rate to drop to 6.25% by the end of the year,” he added.

Nonetheless, the Monetary Council is expected to make a careful and data-driven decision from month to month, as indicated in the press release that followed the rate decision. According to this, instead of “further reducing the base rate,” it now decides on the “rate of the base rate.” So, in addition to the slight reduction, the pause in the interest rate cut cycle was also included in the forward guidance.

Deputy Governor Virág emphasized that the Monetary Council will decide month by month. The wriggle room will be narrow, and special attention will be paid to the stability of the money market, that is, to the exchange rate of the forint.

This article was first published in the Budapest Business Journal print issue of June 28, 2024.

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