The rise in inflation from single to double digits coincided with the onset of Hungary’s transition to a market economy in the late 1980s. Unlike most other transition countries in central and eastern Europe, Hungary had introduced a series of price reforms since the late 1960s;1 therefore, economic liberalization in the late 1980s and early 1990s did not lead to the explosion in prices seen elsewhere (Figure 7.1). Despite this favorable position, inflation in Hungary has been very sticky. Over the last seven years, it has essentially fluctuated in the 20–30 percent range.
Inflation Comparison
(In percent)
Source: International Monetary Fund, International Financial Statistics, 1997.The problems associated with persistent inflation in Hungary have been well articulated, most recently by Suranyi and Vincze (1998) and Medgyessy (1998). For example, one-fourth of the Hungarian population are pensioners whose income has been only partially indexed. Low inflation is also often seen as a precondition for long-term investment and, therefore, sustainable growth. The goal of low inflation is widely accepted by the policymakers in Hungary. The Hungarian government has declared its intention to join the European Union, and there is political consensus on this issue. Achieving an inflation level close to the western European average is an important Maastricht criterion, and although this is not a condition for EU membership, it would signal the country’s readiness to integrate with the European Union and eventually cope with monetary union. With the sharp reduction in the external current account deficit achieved over the past three years, the focus of economic policy will be shifting toward reducing inflation in the next few years. In this respect, it is instructive to review the experience of inflation in Hungary since the early 1990s, and attempt to identify its key determinants.
Hungary’s Inflation Experience
Inflation peaked in Hungary in 1991. After the near doubling of price of household electricity and gas, the liberalization of retail prices of petroleum and diesel fuels in 1991, as well as a devaluation of 15 percent in January 1991, inflation rose to almost 40 percent in mid-1991. Then, the dissolution of CMEA and the associated economic restructuring and collapse in trade led to a decline of about 15 percent in real GDP during 1990–91. This contributed to a rapid fall in inflation to about 20 percent by mid-1992 (Figure 7.2, top panel).
Inflation
Source: Hungarian Central Statistical Office.During 1992–94, inflation fluctuated at about 20 percent. The economic policy stance loosened gradually during this period, at least partly reflecting the concerns of policymakers regarding the deep recession and increasing unemployment (see below). The pickup in inflation in 1995 coincided with the resumption of the pace of macroeconomic adjustment. In particular, energy prices were raised sharply (Figure 7.2, central panel), the effective VAT rate was increased, the forint was devalued, and a temporary import surcharge of 8 percent was introduced. Following the introduction of the March 1995 austerity package, financial policies were tightened considerably (see below). Inflation peaked at just over 30 percent in mid-1995 before gradually declining throughout 1996 and 1997, despite further increases in administered prices.2 By December 1997, the 12-month inflation rate had declined to 18.4 percent.
The cumulative increase in CPI has been sharper than that of PPI since 1990 (Figure 7.2, lower panel), reflecting the rise in administered prices and VAT, and the increase in the relative price of services (which were typically underpriced in centrally planned economies (van Elkan, 1996)). Therefore, a given real product wage has been associated with a comparatively lower real consumption wage over the past seven years.
What Determines Inflation?
A number of recent studies of inflation in Hungary have focused on the key macroeconomic determinants of inflation. Using time series techniques and monthly data for the period 1990:12 to 1995:12, van Elkan (1996) finds a long-run cointegrating relationship for prices that includes money, wages, and the exchange rate. This study finds that the magnitude of the effect of each of these macroeconomic factors on prices is roughly equal. Furthermore, van Elkan also discovers that changes in administered prices have had a statistically significant impact on inflation in Hungary.
Suranyi and Vincze (1998) argue that the exchange rate and wage developments are the most important determinants of inflation in Hungary. They point to other empirical studies done in the National Bank of Hungary, which find that the assessment of the impact of money on inflation is complicated by the numerous structural and institutional changes since the late 1980s. Suranyi and Vincze also argue that expectations have an important role in determining the inflation process in Hungary. In managing Hungary’s planned economy prior to the late 1980s, policymakers had used inflation to solve demand and supply imbalances. Therefore, Suranyi and Vincze argue, inflationary expectations since the start of transition have been rekindled at any sign of macroeconomic imbalance. They also maintain that relative price changes have been an important determinant of inflation in Hungary; however, their role in explaining inflation has diminished recently. In particular, they point out that PPI and CPI have moved in tandem since early 1995 (Figure 7.3).
Consumer and Producer Prices
(Twelve-month growth rate)
Source: Hungarian Central Statistical Office, Monthly Bulletin of Statistics.A Structural Perspective on Inflation
Most economists agree that inflation is a monetary phenomenon. Therefore, it would be surprising not to find a statistically significant relationship between changes in money and inflation.3 However, such a finding is not particularly informative, as it does not necessarily reveal the reasons behind any monetary relaxation or accommodation by the authorities. Similarly, one would expect to find that movements in wages and the exchange rate are highly correlated with inflation. Again, this would tell us little about the direction of causality and how easy or difficult it is to reduce inflation in an economy with a particular wage setting structure or exchange rate regime.
To understand the phenomenon of inflation in a transition economy such as Hungary, one can ask: What are the perceived benefits of inflation, or put another way, what do authorities see as the costs arising from disinflation? There is extensive academic work being done in this area. For example, Cukierman (1992) identifies four “motives” for inflation. First, unanticipated inflation could lead to an increase in output and hence employment if there are nominal rigidities in the economy. Second, higher inflation means higher seigniorage to finance the fiscal deficit. Third, a monetary expansion and subsequently a devaluation could temporarily be accompanied by a real depreciation and help to alleviate balance of payments problems. Finally, Cukierman argues that a central bank that is concerned about the health of the banking system may avoid necessary increases in interest rates (thereby contributing to rising inflation) in order to shelter financial institutions. Ball and Mankiw (1995) point to another structural factor that may be highly relevant: in the presence of “menu costs” in changing prices, asymmetric relative price shocks (such as those relating to administered price changes) could lead to higher inflation.
If the above motives or structural factors play a role, unions raise their demand above what is justified by real economic fundamentals in anticipation of the authorities’ behavior.
Thus, the economy may experience an inflation bias through the wage formation mechanism. Two solutions have been found to break this vicious circle: “precommitment” and “reputation,” both of which may have played a role in controlling inflation in Hungary. Precommitment could take the form of giving control of monetary policy to an independent central bank that is held accountable for price stability. Precommitment could also take the form of an exchange rate peg to a currency with a demonstrated record of low inflation. Reputation can be gained after a prolonged period of anti-inflationary stance by the authorities.
Empirical Findings
Unlike the theoretical literature, empirical evidence on the structural determinants of inflation is scant, not least because of data difficulties. Grilli and others (1991) find that central bank independence reduces inflation in industrial countries; however, Cukierman (1992) finds this relationship to be less robust when developing countries are added to the sample. Ghosh and others (1995) find that pegging the exchange rate is associated with lower inflation. With regard to transition economies, Griffiths and Pujol (1996) find support for the role of relative price adjustments in explaining inflation in Poland. Coorey and others (1996), using a panel of transition economies, find that relative prices have a statistically significant impact on inflation during the initial phase of liberalization. Fischer and others (1996) also use a panel of transition economies to find that a fixed exchange rate regime, fiscal consolidation, as well as a number of indices of economic liberalization, are associated with lower inflation.
Building on the above studies, Cottarelli and others (1998) have attempted a more comprehensive empirical study of the structural determinants of inflation, both in terms of including a larger number of structural variables and the country coverage. Their panel study uses annual data from 1993 to 1996 for 47 countries: 22 industrialized OECD countries; 10 countries from central and eastern Europe; and 15 countries from the states of the former Soviet Union. Their data set included a large number of structural variables such as information on the exchange rate regime; wage indexation; the degree of centralization in the wage bargaining system; the degree to which monetary policy is constrained by the lack of a government securities market; the degree of independence of the central bank; the extent of problems in the banking sector; and relative price indicators. In addition, their model included a number of other variables suggested by the inflation motivation literature, for example, the fiscal deficit; the current account balance; and the degree of openness. Of course, not all of the above variables turned out to be significant. The key significant variables were lagged inflation, the fiscal deficit, the exchange regimes, wage indexation, central bank independence, and relative price changes. It is instructive to interpret inflation developments in Hungary in light of the behavior of these variables.
Past Inflation
Lagged inflation is significant in all specifications estimated in Cottarelli and others, with a positive sign and an elasticity of between ¼ and ⅓, indicating that high past inflation makes it more difficult to reduce current inflation. This finding is indeed not surprising in the context of Hungary, where inflation has fluctuated in a narrow band since the beginning of the transition, and the inertial character of inflation is often cited as an impediment to reducing it rapidly. This result is also consistent with the argument made by Suranyi and Vincze (1998) regarding the critical role that expectations have played in keeping inflation above what is justified by economic fundamentals in Hungary.
A good example of the role of past inflation is the announcement of the 1997 inflation target (see also Chapter II). In Hungary, because of the perceived inflation inertia, the general view among policymakers and trade unions is that the inflation rate cannot be brought down by more than 4–6 percentage points a year without undue output loss. By mid-1996, the average inflation target for the year had been revised to 23½ percent, and, in line with this belief, the government announced that the target for 1997 would be set at 18 percent. During the second half of 1996, inflation dropped rapidly, in fact more rapidly than the authorities had expected, and it was already below 20 percent by the end of 1996. By then, however, the 18 percent figure for 1997 had been incorporated in expectations. Indeed, trade unions were even skeptical about achieving this target, given past experience.
Fiscal Position
Cottarelli and others find that the fiscal position is a robust explanatory variable across a number of data sets and time periods; a more expansionary fiscal stance is typically associated with higher inflation after controlling for other factors. This finding is confirmed after controlling for the endogeneity of the fiscal deficit. The fiscal deficit is not independent of inflation: if nominal interest rates on government debt are, at least to some extent, affected by inflation, interest payments and, hence, the deficit-to-GDP ratio increases with inflation. To allow for this, Cottarelli and others use the government’s primary balance rather than the overall deficit as an explanatory variable.
With regard to the fiscal stance, the relatively tight fiscal policy in 1990–91 (Table 2.1, Chapter II) may have played a role in the sharp decline in inflation between mid-1991 and mid-1992. However, fiscal balances deteriorated sharply during 1992–94, reflecting the collapse in output and tax revenues and concerns of policymakers over the deep recession and the increasing unemployment: the primary balance of the consolidated government dropped by about 6 percent of GDP between 1991 and 1993. By 1994, public finances were no longer in a sustainable position (Chapter IV), fueling inflationary expectations. It is significant that nominal interest rates started rising sharply in mid-1994, possibly signaling an upward revision in inflation expectations.
The 1995–97 fiscal adjustment was initially accompanied by an increase in inflation, primarily due to the exchange rate depreciation and the adjustment in administered prices, which were necessary to redress imbalances in the real exchange rate and in domestic relative prices (see below and Chapter II). The strengthening of fiscal accounts was, however, important in containing inflationary expectations for two reasons. First, it contributed to cool consumption demand. Second, it restored the solvency of public finances, thus reducing the need for monetary seigniorage. Indeed, the improved conditions of public finances in Hungary have significantly boosted the prospects for a rapid, low-cost disinflation in the years ahead (Blanchard, 1998).
Exchange Rate Regime
Begg (1998) argues that it is difficult to assess whether transition economies that have adopted a preannounced or fixed exchange rate regime have been more successful in reducing inflation. This is because, Begg argues, many transition countries have moved to a preannounced or fixed regime only after their economic fundamentals, including inflation, have improved. However, Cottarelli and others control for a number of other economic and institutional variables and also allow for the endogeneity of the exchange rate regime by using the instrumental variables technique. They find that countries with a fixed or preannounced exchange rate regime experience a lower rate of inflation than those with a floating rate system. Thus, the precommitment to a fixed exchange rate appears to enhance anti-inflationary credibility.
Prior to 1995, the exchange rate policy in Hungary was characterized by frequent, and often ad hoc, adjustments.4 Through these adjustments, the authorities tried to strike some balance between the conflicting goals of avoiding an excessive appreciation of the real exchange rate and of containing the inflationary impact of increases in import prices. The result of this approach was poor. The lack of an announced and credible anchor for inflationary expectations did not facilitate the deceleration in wage growth that would have been necessary to achieve disinflation and external competitiveness at the same time. This approach was radically changed in March 1995. Following a devaluation of 9 percent, the March 1995 austerity package introduced a preannounced crawling peg exchange regime as an anchor for inflationary expectations. The empirical results of Cottarelli and others suggest that this step was important in the fight against inflation in Hungary.
Relative Prices
Cottarelli and others find that changes in relative prices significantly affect inflation. The pickup in inflation in Hungary in 1991 followed the liberalization of retail energy prices as well as large increases in household electricity and gas prices. The resurgence of inflation in 1995 again coincided with large increases in administrative prices, particularly energy prices (Figures 7.2, central panel, and Figure 7.4).5
Administered Price Inflation
(Twelve-month growth rate)
Source: National Bank of Hungary.1 Difference between administered price inflation and CPI inflation.Other Factors
Cottarelli and others find two other factors to be important in explaining inflation: (1) wage indexation leads to higher inflation; and (2) the more independent the central bank is, the lower the rate of inflation. Hungary does not have a wage indexation system, and in fact, real wages fell significantly during 1995–96 (Figure 2.7, Chapter II). However, the National Bank of Hungary has gradually gained more independence, particularly since 1995. During 1992–94, the stance of monetary policy could not have been characterized as anti-inflationary. Interest rates were negative in real terms between mid-1992 and the end of 1993, triggering a sharp pickup in domestic demand and thus contributing to a significant deterioration of the external current account. Although since early 1995 the conduct of monetary policy has been complicated by strong capital inflows and reverse currency substitution, the National Bank of Hungary has on the whole succeeded in keeping interest rates positive in real terms through sterilized intervention (Figure 2.3, Chapter II). In late-1996, the Central Bank Law was amended to enhance the independence of the National Bank of Hungary. This was achieved in two ways: (1) all central bank credit to the government (apart from a small temporary facility) was prohibited; and (2) through a “securitization” operation, the government swapped its large stock of non-interest-bearing liabilities to the National Bank of Hungary, which had arisen from past devaluation losses, for interest-bearing foreign exchange denominated liabilities to the central bank (Chapter IV). In fact, the operation was designed in a manner that ensured that the new stock of the National Bank of Hungary foreign exchange claims on the government was identical, in size and maturity, to the net foreign exchange position of the central bank. This strengthened the profit position and financial autonomy of the National Bank of Hungary. The increased independence of the central bank improves prospects for faster disinflation.
Conclusion
Inflation in Hungary has exhibited a large degree of inertia; this by itself has affected inflationary expectations and reduced the speed of disinflation. A number of measures that have been introduced in Hungary since early 1995 have been of critical importance in the fight against inflation. The most important of these measures are the sizable degree of fiscal adjustment between 1994 and 1997; the introduction of the crawling peg exchange regime; and the increased independence of the central bank. The rise in administered prices has also played a key role in explaining inflation. Prospects for a faster pace of disinflation are now favorable for two reasons. First, the need to increase administered prices well beyond the prevailing rate of CPI inflation is coming to an end; and second, the policies of the past three years should increase the anti-inflationary credibility or “reputation” of the authorities, thereby making further reductions in the rate of inflation less costly.
References
Ball, Lawrence, and N. Gregory Mankiw, 1995, “Relative Price Changes as Aggregate Supply Shocks,” The Quarterly Journal of Economics, Vol. 110, Issue 1, pp. 162–93.
Begg, David, 1998, “Disinflation in Central and Eastern Europe: The Experience to Date,” in Moderate Inflation: The Experience of Transition Economies, edited by Carlo Cottarelli and György Szápary (Washington: International Monetary Fund and National Bank of Hungary).
Blanchard, Olivier, 1998, “The Optimal Speed of Disinflation. The Case of Hungary,” in Moderate Inflation: The Experience of Transition Economies, edited by Carlo Cottarelli and György Szápary (Washington: International Monetary Fund and National Bank of Hungary).
Coorey, Sharmini, Mauro Mecagni, and Erik Offerdahl, 1996, “Disinflation in Transition Economies: The Role of Relative Price Adjustment,” IMF Working Paper No. 96/138 (Washington: International Monetary Fund).
Cottarelli, Carlo, Mark Griffiths, and Reza Moghadam, 1998, “The Nonmonetary Determinants of Inflation,” IMF Working Paper (forthcoming; Washington: International Monetary Fund).
Cukierman, Alex, 1992, Central Bank Strategy, Credibility, and Independence: Theory and Evidence (Cambridge, Massachusetts: MIT Press).
Fischer, Stanley, Ratna Sahay, and Carlos Végh, 1996, “From Transition to Market: Evidence and Growth Prospects” (mimeo, International Monetary Fund).
Ghosh, Atish, Anne-Marie Guide, Jonathan D. Ostry, and Holger C. Wolf, 1995, “Does the Nominal Exchange Rate Regime Matter?” IMF Working Paper No. 95/121 (Washington: International Monetary Fund).
Griffiths, Mark, and Thierry Pujol, 1996, “Moderate Inflation in Poland: A Real Story,” IMF Working Paper No. 96/57 (Washington: International Monetary Fund).
Grilli, Vittorio, Donato Masciandaro, and Guido Tabellini, 1991, “Political and Monetary Institutions and Public Financial Policies in the Industrial Countries,” Economic Policy (October).
Medgyessy, Peter, 1998, “Introductory Remarks,” in Moderate Inflation: The Experience of Transition Economies, edited by Carlo Cottarelli and György Szapáry (Washington: International Monetary Fund and National Bank of Hungary).
Surányi György, and János Vincze, 1998, “Inflation in Hungary (1990–1997),” in Moderate Inflation: The Experience of Transition Economies, edited by Carlo Cottarelli and György Szápary (Washington: International Monetary Fund and National Bank of Hungary).
van Elkan, Rachel, 1996, “Inflation Inertia in Hungary,” in Hungary—Selected Issues, IMF Staff Country Report No. 96/109 (Washington: International Monetary Fund).
By 1989, the price of about 80 percent of consumer products had already been freed.
In particular, household prices of electricity and gas were raised by 25 percent and 18 percent, respectively, in March 1996, and again by about 25 percent in January 1997.
In the case of a transition country, it may be necessary, of course, to control for the structural and institutional changes that have occurred and affected money velocity and real output.
In 1992, there were three devaluations ranging from 1.6 percent to 1.9 percent. The five devaluations in 1993 resulted in a depreciation of 15 percent. In 1994, there were seven devaluations for a total of 16.8 percent, including a larger-than-usual depreciation of 8 percent in August 1994, which reflected growing concerns over the size and persistence of the external current account deficit.
The above evidence and the results in Cottarelli and others regarding the importance of relative price changes in inflation are somewhat at odds with the argument made by Suranyi and Vincze that relative price changes may have only played an important role in the initial phase of transition in 1990–91. One possible reason for this divergent view is that Suranyi and Vincze base their conclusion on statistical analysis that does not include the most recent (post-1994) period.
