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Inflation to drop to 3% target in H2 2012 with current 6% base rate

Inflation in Hungary could drop to the central bank's 3% midterm target in the second half of 2012 with the current 6% base rate, the National Bank of Hungary (MNB) said in its fresh Inflation Report.

The report projected annual average inflation to drop to 4% this year and to 3.4% in 2012 from 4.9% last year.

The country's GDP is seen to grow by 2.9% in 2011 and 3% in 2012 after rising by 1.2% in 2010.

The report is the first one based on a new model, which focuses on the monetary steps needed to reach the inflation target, and handles central bank interest rates (as well as exchange rates) as endogenous factors. The earlier projections were conditional ones, assuming no change in monetary conditions, including unchanged interest rates.

In a statement published after a rate-setting meeting of the Monetary Council on Monday, the panel said it believed inflation would exceed the target in the short term because of price shocks, but would still fall close to the 3% “price stability” target by the end of 2012 without further monetary tightening. To reach the inflation target in 2012, it could require keeping the current interest rate for a longer period, the statement said.

In the Council's assessment, the pace of economic growth could pick up over the horizon relevant to monetary policy, but it will still remain under its potential, the statement said.

On Monday the Council left the base rate unchanged in a unanimous decision.

The staff included three alternative scenarios in the report at the request of the Council, one assuming a steady fall of investments, another a reduction in banks' propensity to lend, and a third one displaying uncertainties of the effects of global cost shocks.

If the drop in investments is longer than expected, GDP growth could remain in the 2-2.5% range until the end of 2012. The output gap could narrow as a result and its disinflationary effect would be less. This would move the interest rate path somewhat upwards, but without the need for any significant tightening.

Consumer demand could be lower if banks' retail lending conditions remain tighter than assumed under the base scenario. The resulting steeper drop of inflation would leave room for a gradual cut of interest rates in 2012. The mix of looser monetary conditions and lower demand would result in an inflationary path very similar to the base scenario, but with lower GDP growth up to middle of 2012.

The third alternative version would have the biggest inflationary effect. This scenario assumed that cost pressures work through to core inflation as inflationary expectations are insufficiently anchored and wages rise even more as the economy picks up. Even with a monetary tightening, this path would result in half a percentage point higher inflation without any significant effect on the base GDP forecast.

The report noted that the alternatives resulted in less change to the inflationary path and bigger change to growth compared to the base scenario because monetary policy is responsive in the new model and thus offsets most of the inflationary effects.