This is why Hungary's central bank cut rates less than expected

After the central bank had paved the way in recent weeks to accelerate the pace of interest rate cuts, it surprisingly lowered the base rate by "only" the usual 75 basis points. There was a reason for the cautious move, as a number of risk factors have unfolded in recent days that have affected investor sentiment and started to weigh on the forint exchange rate.

As some of the interest rate cuts expected from the central banks of developed economies started to be priced out of the market, the Hungarian yield advantage started to erode. On the domestic side, investors have become sensitive to economic policy risks, with the fiscal situation, strained relations with the EU and the new plan for credit market intervention all worrying the market.

That is why everyone was keen to see the rationale for today's cautious rate move. In the end, the central bank chose the option of pretending that the possibility of moving to a 100 basis point rate cut had never arisen. Thus, it did not need to present any concrete arguments against the acceleration of monetary easing, as the pace remained unchanged at 75 basis points.

Accordingly, the tone of the Monetary Council's statement has not changed. The outlook is literally the same as in the December statement, and there is nothing new in the document as a whole. It says that "risks surrounding global disinflation and volatility in international investor sentiment warrant a careful approach to monetary policy", and that the data-driven mode remains.

In the following you can read the MNB's statement without any changes but some parts highlighted by Portfolio.

Rationale

The primary objective of the National Bank of Hungary (MNB) is to achieve and maintain price stability. Without prejudice to its primary objective, the MNB preserves financial stability and supports the Government’s economic policy, as well as its policy on environmental sustainability.

The US and Chinese economies grew strongly in 2023 Q4, while European economic growth stagnated. The short-term economic outlook is still exposed to downside risks, which is further exacerbated by the generally tense geopolitical situation.

Inflation in the euro area rose temporarily; however, underlying developments still point to a decline. In the US, the pace of price increases was slightly stronger than expected in December. Weakening global economic demand and lower commodity prices compared to previous years suggest a continued decline in inflation rates. However, the increase in international freight costs due to the Red Sea conflict may cause disruptions in global value chains, leading to a renewed rise in freight costs. Despite geopolitical tensions, oil prices have remained unchanged at around USD 80 and European gas prices have continued to decrease.

International risk appetite has been volatile since the December interest rate decision. Sentiment in global financial markets was influenced by expectations for the interest rate policies of the world’s leading central banks, incoming macroeconomic data and developments related to the conflicts in the Middle East. Based on market pricings, the Federal Reserve’s and the European Central Bank’s interest rates have peaked, and therefore market participants’ attention was focused on the timing of the start and expected size of interest rate cuts over the period. In the CEE region, the Czech central bank lowered its policy rate by 25 basis points, while the Polish and the Romanian central banks left monetary conditions unchanged.

Following the rebound in 2023 Q3, domestic growth was subdued in 2023 Q4. In November, industrial and construction output and the volume of retail sales fell in annual terms. Primarily due to high inflation, the economy declined moderately throughout 2023, with the outstanding performance of agriculture dampening the decline. The household confidence indicator continued to improve slowly in December. Accompanied by a high level of employment, the labour market remains tight and the unemployment rate is low even by EU standards.

As inflation moderates, real wages rise and confidence gradually recovers, leading to a recovery in domestic demand, a more balanced economic growth is expected in 2024. Persistently weak European economic activity is holding back domestic exports, but with the pick-up in the production of new export capacities built recently, Hungary’s export market share is expected to increase over the entire forecast horizon. Hungary’s economic performance may have been in the range of (-0.6)–(-0.4)% in 2023. GDP is projected to increase by 2.5–3.5% in 2024, by 3.5–4.5% in 2025, and by 3.0–4.0% in 2026.

Disinflation has been widespread and persistent in the Hungarian economy. The general decline in domestic inflation continued at a rapid pace in December. Consumer prices rose by 5.5% in annual terms and core inflation stood at 7.6%. The incoming inflation data was sharply below analysts’ expectations. The consumer price index fell significantly by 2.4%age points, while core inflation declined by 1.5%age points from the previous month. Compared to other European countries, inflation fell to the greatest extent in Hungary last year. Consequently, domestic inflation was one of the lowest in the region at the end of the year. The trend-like slowdown in underlying inflation is indicated by the fact that the annualised three-month change in core inflation has been around 3% since September.

Disinflation is expected to continue in 2024 Q1, and as a result, inflation is likely to approach the upper bound of the tolerance band in the spring months (Editor's note: this means 4%) Disciplined monetary policy, the Government’s measures to strengthen market competition, subdued domestic demand, and a significantly lower external cost environment than in recent years jointly support a further moderation in price growth. In Hungary, as in other countries, inflation may rise temporarily from the second quarter due to base effects. The consumer price index is expected to return to the central bank inflation target persistently in 2025. Annual inflation may be between 4.0 and 5.5% in 2024 and between 2.5 and 3.5% in 2025 and 2026.

The rapid and substantial improvement in the external balance continued. In November 2023, the monthly current account balance was in a significant surplus not seen for over seven years. The sustained improvement in the external position reflects shrinking imports caused by significantly lower energy prices and the adjustment of energy consumption on the one hand, and by the decline in domestic demand on the other. Developments in the current account balance were primarily driven by changes in the balance of goods, while the services account remained in surplus. The current account balance-to-GDP ratio improved by more than 8%age points in 2023. As a result, the surplus recovered at an unprecedented rate even in historical comparison.

In 2023, the annual current account balance turned slightly positive, and it is expected to increase further in 2024 and in the coming years. Looking ahead, the utilisation of new export capacities built recently and the improving global economic environment are expected to give new impetus to exports in the coming years. The inflow of EU funds that started in December will contribute to a strengthening in Hungary’s net lending and an increase in central bank foreign exchange reserves which are already at historically high levels.

Based on the 2023 end-of-year projection by the Ministry of Finance, the government deficit may have amounted to 5.9% of GDP in 2023. According to the projection in the MNB’s December Inflation Report, the government deficit-to-GDP ratio may be between 2.9% and 3.9% in 2024. The government debt ratio may have fallen to around 73% of GDP in 2023, and it is expected to decline further over the forecast horizon.

Over the past few months, disinflation in the Hungarian economy has been stronger than expected, while external and domestic demand pressures remain persistently low. As a result of the trend-like improvement in Hungary’s current account balance, the country’s risk perception improved further despite a volatile global sentiment. According to the Monetary Council, this allows the base rate to continue to be lowered. In line with this, at its meeting today the Monetary Council cut the base rate by 75 basis points to 10%. Accordingly, the lower bound of the interest rate corridor, i.e. the O/N deposit rate, will be reduced to 9%, while the upper bound, i.e. the O/N lending rate, will be lowered to 11%. Positive real interest rates will help to continue disinflation and achieve the inflation target. As inflation approaches the central bank tolerance band, real interest rates are expected to decline.

The MNB continues to simplify the central bank monetary policy toolkit started in autumn 2023. In the Monetary Council’s assessment, the long-term deposit facility has been successful in fulfilling its stabilising function, and therefore the Bank will discontinue its use with effect from 31 January. In addition, in the Council’s judgement, the use of the swap facility providing foreign currency liquidity in December 2023 contributed to the maintenance of stability in the swap market again, and therefore the MNB will continue to use the instrument.

Risks surrounding global disinflation and volatility in international investor sentiment warrant a careful approach to monetary policy. The Council is constantly assessing incoming macroeconomic data, the outlook for inflation and developments in the risk environment. In the coming months, decisions on any further reductions in the base rate and their optimal pace will be made on the basis of this information, in a data-driven manner.

The abridged minutes of today’s Council meeting will be published at 2 p.m. on 14 February 2024.

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