Inflation forecast

Compared to our December forecast, we have decreased our short-term inflation expectations, but maintain a similar forecast for price increases over the medium term. Inflation is expected to steadily rise towards the medium-term inflation target over our forecast horizon.

The reductions in regulated prices carried out in several steps have decreased inflation considerably over the short run, and inflationary pressure from foreign trade partners might also remain subdued. Restrained wage dynamics and lower inflation expectations generally support the low inflation environment.

Chart 1–1 Fan chart of the inflation forecast

Source: MNB

The CPI may remain substantially below target this year and be close to the price stability target of 3 per cent in 2015. In line with the more favourable underlying inflation trends observed in the past period, inflation in 2014 is expected to be lower than our December forecast and close to the forecast in 2015 (Chart 1-1).

Chart 1–2 HICP inflation in the eurozone

Source: ECB, Consensus Economics

Core inflation excluding indirect tax effects shows historically low dynamics, mainly as a result of restrained inflation in market services and the slowing global price dynamics of imported products. In addition, subdued domestic demand and low wage dynamics contribute materially to restrained price changes in core inflation items. On the other hand, we have raised our forecast for core inflation based on the gradual pass-through of the weaker exchange rate into consumer prices (Chart 1-2).

On the whole, factors determining medium-term inflation trends point to a low inflation environment.

The real economy has a disinflationary impact over the entire forecast horizon. Although the output gap may close in the second half of our forecast period, the structure in which this occurs ensures that inflationary pressures from the real economy should remain subdued.

The narrowing of the output gap will mainly be driven by the recovery in the export sector and investment, while the effect of stronger consumption will only be gradually felt. According to our expectations, although GDP may

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Per cent Per cent

HICP inflation in the eurozone ECB staff projection

Consensus Economics

Chart 1–3 CPI with and without indirect taxes and subsidies

Source: MNB

Efforts to restore low profitability may continue to be a determining factor in corporate behaviour. In the low demand environment, price adjustment remains limited, and therefore firms attempt to improve their profitability mainly by cutting wages and other costs. Slack labour market conditions and the downward revision of inflation expectations also contribute to restrained wage dynamics. The persistently low inflation environment may reduce price and wage expectations over the long term, thus helping to maintain low inflation over the medium term (Chart 1-3).

We project subdued price increases in non-core items over the entire forecast horizon. Global crude oil prices have fallen since December and, owing to globally favourable harvest results, unprocessed food prices are low. Futures contracts for both crude oil and foods point to moderate dynamics.

The direct impact of government measures on inflation may remain below the historical average over our entire forecast horizon. The new round of regulated price cuts, passed at the beginning of the year, resulted in a lower price level compared to our December assumption. The impact of this on average inflation for 2014 is -0.2 percentage points and -0.3 percentage points for 2015. In light of this, we maintain the assumption that regulated

energy prices will not rise until the end of our forecast horizon. In addition, we expect restrained dynamics in the regulated prices of non-energy items as well (Chart 1-4).

Chart 1–4 Decomposition of the inflation forecast

Source: MNB

Table 1-1 Details of the inflation forecast

2012 2013 2014 2015 predominantly disinflationary government measures and lower inflation expectations. The rise in consumer prices may be far lower than the medium-term inflation target in 2014 and is expected to rise close to the 3 per cent

CPI CPI excluding indirect taxes and subsidies

-2

Core inflation Non-core inflation Indirect tax effect Consumer price index

Box 1–1 Underlying inflation in our forecast

The MNB has developed various measures of underlying inflation to capture longer-term inflationary trends. Eliminating the transitory effects of highly volatile items and government measures from the price index provides a more reliable picture of underlying inflationary pressure in the economy, particularly over the medium term, which is the relevant horizon for central bank decision making. In our assessment of the inflation stance, we put particular emphasis on monitoring demand-sensitive and sticky-price inflation.

We cannot, however, prepare all of the above indicators in a forward-looking manner, due to the highly aggregated nature of our forecast system and for reasons of calculation methodology. Our forecast captures underlying inflation trends mainly through developments in core inflation adjusted for taxes. Over the past year and a half, this indicator has co-moved closely with the other two underlying measures. A significant gap between core inflation adjusted for taxes and the other two underlying indicators only occurred during periods of food price shocks (2007-2008, 2010-2011); otherwise, the indicators showed similar dynamics.

According to our current forecast, the weaker exchange rate compared to 2013 H2 will gradually shape developments in underlying inflation in the upcoming quarters. The exchange rate is reflected in core inflation adjusted for taxes mainly in the changing price of tradables and, to a smaller degree, of processed foods. However, the subdued domestic demand since the recession may substantially limit the weaker exchange rate from being passed on to consumer prices and thus pass-through may be smaller compared to the pre-crisis period.

Over the medium term, core inflation is shaped by persistently low imported inflation, the adjustment of inflation expectations and depressed developments in wages; as a result, core inflation adjusted for taxes may gradually return to a value consistent with price stability from 2015 (Chart 1-5).

Chart 1–5 Forecast of core inflation excluding indirect taxes

Source: MNB 0

1 2 3 4 5 6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Per cent

core inflation excluding indirect taxes sticky price inflation

demand sensitive inflation

Box 1–2 Tax effects shaping current inflationary trends

Recent years have seen the introduction of several tax changes which resulted in temporary increases in inflation. Changes in indirect taxes exert a significant impact in terms of monetary policy, if they entail permanent price increases by spilling over through corporate cost structures. However, the probability of indirect taxes triggering second-round effects is low and they are not expected to affect medium-term trends. In light of this, it is warranted to adjust time series for indirect tax effects when considering monetary policy.

Value added tax is a typical example of the impact of indirect taxes. Consumer prices are adjusted for VAT based on the estimated effect, as VAT may be passed on to different degrees based on the prevailing state of the economy. If demand is weak, hikes in VAT are unlikely to fully make their way into consumer prices. The price index is also adjusted for the effect of excise duties, the other typical form of indirect tax, and other sales taxes.

Several one-off measures were recently introduced (such as the increase in the retail margin for tobacco products¹) which do not qualify as classical tax changes. It is warranted to eliminate these effects, because from a monetary policy point of view their impact mechanism on the consumer price index completely resembles a change in a consumption tax: they resulted in a temporary rise in inflation for a narrow range of goods and will presumably have no second-round inflationary effects.

In February 2014, the CPI stood at 0.1 per cent, while inflation adjusted for indirect taxes² as determined by the MNB was -0.7 per cent. For the most part, the gap between inflation and inflation adjusted for indirect taxes stems from the following measures: the introduction and increase in the financial transaction levy (January and August 2013), the increase in the retail margin for tobacco products (July 2013) and the two monthly free cash withdrawals of up to HUF 150,000 introduced in February of this year (Table 1-2).

Table 1-2 Indirect tax effect in consumer price index estimated by MNB

Source: MNB

1 See the June 2013 Inflation Report for a more in-depth analysis of the increase in the retail margin on tobacco products.

2 The difference between the constant tax rate CPI published by the Central Statistical Office, and inflation adjusted for indirect taxes calculated by the MNB stems from the fact that the indirect tax effect estimated by the MNB differs from the technical effect applied by the CSO for determining the constant tax rate CPI in terms of both the tax measures taken into account and their quantification.

February 2014 2014 average February 2014 2014 average

Increase in retail margin on cigarettes 0.7 0.5 1,0 0.7

Financial transaction levy 0.3 0.2 0.5 0.3

Two cash withdrawals free of charge every month up to a total of 150,000 HUF -0.1 -0.1 -0.2 -0.2

0.8 0.6 1.3 0.9

Total

Tax content Inflation Core inflation