Three things may force Hungarian cenbank to turn around

The central bank’s 26 March policy meeting and the subsequent official statement of the Monetary Council took the market by surprise.

Although the bank raised its overnight deposit facility rate by 10 basis points to -0.05% (and tightened liquidity for the following quarter by HUF 100 billion), both Governor György Matolcsy and Deputy Governor Márton Nagy stressed that this was a specific, one-off decision and it was not the start of a rate hike cycle, whereas market players were expecting the NBH to start and then continue tightening.

The central piece in the central bank’s communication was the deteriorating external environment and its potential dampening effect on Hungary’s inflation. This was more or less the argument why further rate hikes are not necessary, and why the NBH will instead switch to a data-driven mode. According to an unofficial explanation, the unexpectedly hawkish rhetoric (i.e. the unbroken commitment to loose monetary policy) was caused by the significant forint appreciation between mid-January and mid-March.

The massive surprise power of the bank’s rhetoric is reflected in the forint’s immediate sharp depreciation that followed the MPC’s statement, which also had to do with speculative capital betting of HUF easing. The NBH is in a difficult position right now, since inflation data show a considerable domestic price pressure and there is no sign of the turnaround the bank said was the reason why the tightening in March was a one-off measure.

It is no wonder that analysts keep trying to figure out what could persuade or rather force the bank to raise rates further.

Pasquale Diana, head of CEEMEA Economics at Morgan Stanley in London is one of the experts who delved into this subject. He listed a couple of factors which make it odd that the NBH is so stubbornly committed to maintaining its extremely loose monetary policy stance.

• Hungary has one of the highest rates of core inflation not only in CEE, but also in all of Europe: According to Morgan Stanley’s diffusion index, roughly 50% of the index is now growing at an above 3% annual rate, which suggests that inflation has now fully normalised.
• Wages are growing at a double-digit pace.
• The output gap closed in 2015 and is now one of the highest in Europe, according to European Commission estimates.
• Even the current account surplus has fallen to near-zero (from a peak of 6%) as a result of strong demand.
• Even after the March 10bp increase in the deposit rate, Hungary's real rates remain among the lowest in the EM universe, on MS estimates.

If the economy shows some signs of overheating, inflation is back at target (if not above) and other central banks in the region have started to normalise rates (CNB), why is the NBH so resolutely dovish?

, ponders Diana.

In his view, the answer is that the NBH does not believe that keeping rates below some level of 'neutral' implies a lot of macro risk. And it remains sceptical about the whole notion that the economy may be overheating.

Moreover, the NBH likely feels that raising rates more aggressively in an environment where the ECB is on hold could attract unwanted HUF gains.

Diana noted that clients often ask - what needs to change for the NBH to step up the pace of tightening to more than once a quarter?

“It seems unlikely to us that the ECB turns hawkish or that the broader external balance (C/A + EU funds) turns negative any time soon. We think we need to see both headline and core inflation heading above 4%Y (and continuing to accelerate), but this alone may not suffice," he said.

We may need to see EURHUF move higher, probably to well above 330, HUF depreciate versus CEE peers, and the yield curve steepen as more inflation premium gets built in.

Such a combination may well cause the NBH to want to step up its normalisation pace. But the bar seems fairly high, given the bank's dovish reaction function, Diana concluded.

(Cover photo by Getty Images Hungary / Bloomberg)

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