Hungary: Central Bank cuts base rate more than expected; signals end of rate cut cycle
July 21, 2015
At its meeting on 21 July, the Central Bank of Hungary (NBH) cut the base rate by 15 basis points from 1.50% to 1.35%. This was a fifth consecutive rate cut the Bank has made after having kept it on hold from July 2014 to March of this year. Market analysts had expected a slightly more moderate reduction in the rate to 1.40%.
In the Central Bank's view, the Hungarian economy is projected to accelerate, although it will still continue to perform below potential with the negative output gap closing only gradually. While the NBH sees that domestic demand is speeding up, external demand remains subdued due to a lengthy recovery in some of Hungary's export markets. Despite the fact that employment has increased, unemployment is still high compared to historic levels. As for recent economic indicators, the Bank pointed out that the trade surplus rose notably in May and that retail sales have stabilized in recent months. Conversely, industrial production growth slowed somewhat in May. Going forward, the Bank sees that private consumption will strengthen, boosted by subdued inflation, a reduced need for deleveraging as well as rising employment. Investment is also expected to accelerate gradually, supported by recovering economic activity and the Central Bank's extended Funding for Growth Scheme.
Regarding price developments, the Bank noted that inflation remained low in June, despite a slight increase, though was in line with the Bank's projections. In the Bank's assessment, inflationary pressures are expected to remain subdued for a prolonged period as there is spare capacity in the domestic economy, low inflation in external markets and subdued imported inflation. The NBH projects that inflation will only return to near its inflation target of 3.00% at the end of 2016.
As for international developments, the Bank noted that international investor confidence has moderated lately. While risk aversion rose due to concerns over the Greek crisis as well as turmoil in the Chinese equity market, recently appetite for risk has picked back up slightly. The Hungarian currency has been volatile of late, and had depreciated owing to domestic factors, although it then returned to its appreciating trend when investor confidence improved. The Bank sees that, even though Hungary’s external vulnerability had been reduced, "a cautious approach to monetary policy is warranted due to uncertainty in the global financial environment."
The Central Bank signaled the end of the rate cut cycle in stating that, "the policy rate has reached the level which ensures the medium-term achievement of the inflation target and a corresponding degree of support to the economy." The next monetary policy meeting is scheduled for 25 August.
Meanwhile, the NBH is stepping up efforts to reduce external vulnerability. New measures aim at reducing speculation in the currency market, discouraging banks to hold excess funds at the Central Bank and instead buying government bonds, reducing its risk premia and improving the country’s credit ratings. In order to achieve this, on 2 June, the Bank announced an overhaul of its monetary policy instruments, “to support the refinancing of government debt from domestic forint funding”. The Central Bank will replace the two-week deposit rate as its main policy instrument for a less liquid three-month fixed interest deposit facility, effective 23 September. At the same time, the Bank will drastically reduce the liquidity available in the two-week deposit facility. In another unexpected move, the Central Bank also announced plans to increase the minimum liquidity coverage ratio (LCR) for banks to 100% from the current 60% in 2016. Moreover, on 7 July, the Central Bank said that it will introduce a new interest-rate-swap (IRS) facility with a 10-year maturity, in addition to the three-year and five-year facilities already available, to encourage bank’s purchases of and to move more domestic liquidity in government securities. Banks that use the new 10-year IRS facility have to increase their holdings of government securities by the same size and must maintain their position for at least a year.