Frameworks for Monetary Stability

16 Targets and Instruments of Monetary Policy in Hungary

Carlo Cottarelli, and Tomás Baliño
Published Date:
December 1994
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The ultimate policy objective of central banks is macroeconomic equilibrium—that is, price stability and external balance. However, conditions for conducting monetary policies vary significantly in time and space. So do the established definitions of price stability and external balance. For countries in transition from a nonmarket to a market economy, such as Hungary, these ultimate objectives cannot be defined as zero inflation and strict external current account balance.

Yet, the functions of the Magyar Nemzeti Bank—the National Bank of Hungary (NBH)—stipulated by law are identical to those of most other modern central banks. The NBH shall safeguard the stability of the forint and maintain external balance. In practice, these objectives manifest themselves in persistent efforts to reduce the rate of inflation, as well as in the Bank’s external debt and reserve management policy.

Not only are the ultimate goals similar under different macroeconomic conditions, but also the characteristics of a successful monetary policy regime. These are, for sake of brevity, the three c’s: consistency, credibility, and clarity. Consistency means that the goals, instruments, and actions of the central bank are reasonably coordinated. Credibility means that the economic agents and political decision makers have confidence in the ability of the central bank to pursue its goals. Clarity, especially important in transition countries, stands here to mean that the shapers of public opinion and the interested members of society understand and accept those goals. In reviewing the evolution of Hungarian monetary policy, reference is made to these characteristics.

The history of contemporary monetary policy in Hungary is brief. Prior to the systemic changes of 1990, as a side effect of Hungary’s Fund membership, statistics on main monetary aggregates were prepared only after 1982. Broad money, cash in circulation, domestic and net foreign assets, and net credit to government had meaning even in the so-called monobank system, in which almost all state enterprises and cooperatives were forced to hold their accounts at the NBH and were provided with working capital and investment credits. Under central planning, direct control over these monetary aggregates obviated a meaningful definition of terms such as reserve money or refinancing credits. Autonomous monetary policy decisions did not exist at that time, since the large commercial loan portfolio of the National Bank only mirrored government (party-state) decisions within the framework of one-year and five-year plans.

The two-tier banking system was re-established in Hungary in 1987 and the NBH got rid of its commercial banking functions. Its independence in the conduct of monetary policy started in earnest only in 1990, first by a public statement of the Prime Minister, József Antall, that he and his government will not directly influence decisions to be made by the National Bank. Then at the end of 1991, when the Act on the National Bank of Hungary was approved by Parliament, legal autonomy was formally bestowed on the central bank.

The large degree of independence provided by the Act is but one aspect of monetary policy. The other is the constraints imposed by the economic and financial conditions of the transition, including the heritage from the former regime.

The major constraints on monetary policy are: (1) a large external debt burden, the greatest share of which is found in the balance sheet of the NBH, (2) a large public debt, (3) an undercapitalized banking sector, (4) an undeveloped capital market, and (5) an oversized budgetary and social security system, with a tendency to produce large deficits.

Under such conditions, a consistent economic policy from 1990 on required drastic adjustment and structural measures to the economy. Hungarian economic policy is often referred to as gradualist. Although there is an element of truth in this, over the past four years a broadly consistent macroeconomic adjustment has been implemented. In this period, a profound liberalization of trade, prices, and wages took place; production subsidies and most consumption subsidies were abolished; foreign trade was shifted from the protected arrangement of the Council for Mutual Economic Assistance (COMECON) to Western markets. All these changes affected the price level, since macroeconomic stabilization in real world economy can only be achieved after real price adjustment—that is, at a higher level of prices. This explains the accelerated increase of both consumer and producer prices since 1990.

Between 1990 and 1993, official real gross domestic product (GDP) fell by about 20 percent, and the fall in industrial output was even larger. The unemployment ratio jumped from almost zero to a peak of 13 percent. In 1991, inflation measured by the consumer price index (CPI) in the middle of the year reached a peak of 38 percent (annual rate).

The first three years of the transition period also revealed remarkable positive developments: (1) there was a sharp rise in the private households savings ratio (increase of private households financial assets to disposable income) from the historical trend of 2–4 percent to 14 percent in 1992; (2) while budget deficits and enterprise credits were financed by private savings, external current account surpluses permitted a reduction in net foreign debt and a buildup of foreign exchange reserves; (3) Hungarian enterprises had begun to adjust to the requirements of Western markets with a sizable increase until the end of 1992 in exports in convertible currencies, substituting for the collapse of COMECON.

During this period the internal circumstances of the conduct of monetary policy also improved. At the end of 1990 the National Bank stopped providing the budget with preferential credit. Since then, the budget deficit has been financed indirectly through treasury bill auctions and bond issues. The central bank is authorized to buy a limited amount of state debt instruments in conjunction with other market participants. This way NBH gets marketable assets that may be used for monetary policy actions in open market operations. The financing of the budget deficit is market based; both the nonbank sector (including private households) and the banking sector hold large amounts of government securities. The latter are used as collateral in repurchase agreements (repos), which constitute a main vehicle for the central bank to meet the short-term (less than one year) liquidity needs of commercial banks.

In addition an agreement has been reached between the Ministry of Finance and the National Bank to securitize old outstanding budget debt in the balance sheet of the central bank.

Current macroeconomic tendencies are mixed. The rate of inflation is still high (CPI was 23 percent on average in 1992 and 22.5 percent in 1993), and now headline inflation stands at 17 percent. Foreign currency reserves increased further compared with their level at the end of 1992. As the current account showed a major deficit in 1993, a high reserve level totaling more than six months of imports was achieved by external borrowing considerably in excess of debt-service payment and by a strong inflow of foreign direct investment. In all, foreign direct investments covered two thirds of the current account deficit in 1993 (see Charts 14).

Chart 1.Annual Percentage Change in Consumer Prices

Chart 2.Foreign Debt and Foreign Exchange Reserves

(In billions of U.S. dollars)

Chart 3.Total Exports and Imports

(In millions of U.S. dollars)

Chart 4.Foreign Direct Investment (FDI) in Cash

As a result, Hungary’s gross and net external debts increased in 1993, but its objective is to stabilize the level of net external debt. Assuming that foreign direct investment will be around this year’s level, the current account deficit should be reduced by about $1 billion (Hungarian Ft 100 billion). The objective of improving the country’s external position is as important as curbing inflation.

Instruments and Targets

What sort of monetary policy can be conducted against this background? It is certain that under fast-changing socioeconomic conditions, monetary authorities cannot credibly set and follow strict predetermined rules. In the rules versus full policy discretion debate a central bank of a transition country will probably opt for more discretion. However, too many goals and too much policy discretion do not score well on grounds of credibility and consistency. Hence there is a need after a certain consolidation period to establish intermediate targets.

Monetary aggregates seem logical candidates. However, they are sensitive to changes in the demand for money, in itself highly unstable in a transition country, given shifts in portfolios of households and enterprises. Therefore the conventional aggregates do not lend themselves to strict targeting. Alternatively, explicit targets for inflation can be easily communicated to the public. But it is difficult to set credible targets; economic agents tend to regard the forecast of the central bank as a minimum expected inflation rate. Consistent inflation targeting presupposes certain measures of monetary aggregates. Consequently, the various money supply aggregates should be monitored on a continuous basis, not as targets but as important indicators. They may help to find out, for instance, whether the market expects the acceleration of inflation or whether domestic demand is likely to grow in the short run, since both of these developments are preceded by an increase in the stock of the most liquid assets.

There are now several instruments in the Hungarian financial market, ranging from government bonds with maturities of several years to fixed deposits, domestic foreign currency deposits, bank-issued bonds, certificates of deposit, and various treasury bills. These instruments have positive interest rate elasticities of demand, and they can substitute for each other. Therefore, it is not easy to draw far-reaching conclusions from changes in various, broader monetary aggregates and it is even difficult to define them. In Hungary, at present only the most narrowly defined and the most broadly defined money supply aggregates and their relations to each other may provide relevant information.

The broad money supply is highly affected by whether the budget deficit is primarily financed by the banking system and whether the necessary legal and institutional conditions under which final savers can directly obtain government securities are established. In this respect, the ratio of monetary and nonmonetary financing of the budget deficit can also be regarded as an important indicator.

Exchange Rate Policy

In a small open economy such as that of Hungary, the exchange rate can be rationally selected as an operational intermediate target.

Other transition countries, like Poland or the Czech Republic, also opted for this anchor in their macroeconomic stabilization program. Exchange rate is a clear guide to policy, but can raise serious credibility questions, too. The problem is that with creeping domestic prices and expectations of further price level increases, a nominally pegged domestic currency will be seen as continuously appreciating against major foreign currencies. Lasting appreciation will hurt exports and favor imports, and will lead to a trade deficit. Temporary factors may counterbalance the effects of appreciating domestic currency on price competitiveness of home production (as in Hungary in 1991 or in the Czech Republic in 1993), but continuous appreciation is not consistent with policies for sustained export-based growth. This is why Hungary selected the real effective exchange rate, rather than a nominal exchange rate, as an anchor. Thus nominal devaluations are needed to prevent the exchange rate from appreciating against the basket (evenly split between the U.S. dollar and the European Currency Unit (ECU) or the deutsche mark).

The real exchange rate will remain one of the intermediate targets. However, more attention should be paid in the future to changes in unit labor costs and to price movements in the nontradable sector. Although a devaluation of the forint has a price-increasing effect in the tradable sector almost fully, whether or not a nominal devaluation contributes to the improvement of the trade balance depends on whether the devaluation is accompanied by a decrease in real wages and prices in the nontradable sector. If this is not the case, then exchange rate policy cannot influence the real value of the forint. Therefore, it is necessary to underline the importance of restraint in price and wage demands.

Exchange rate policy, under the present macroeconomic situation, has to apply nominal devaluations of the forint in accordance with the targeted rate of inflation if a neutral (nonappreciating) real effective exchange rate is to be maintained. Throughout 1993 the forint was overvalued by some 6 percent in real terms, and this overvaluation was eliminated only at the end of 1993 (see Charts 5 and 6). If the central bank adopts the policy of slight, but frequent, devaluations, this situation can be avoided in the future. In addition, such a practice would minimize currency speculation.

Chart 5.Annual Percentage Change in Consumer and Producer Prices

Chart 6.Official Exchange Rates of the National Bank of Hungary and Real Effective Exchange Rate Index, 1990–931

(Year 1992=100)

1 A figure over 100 indicates the overvaluation of the forint.

At present, the division of competence between the central bank and the Government in exchange rate policy is such that the NBH has a plus or minus 5 percent margin to maneuver in relation to the midpoint exchange rate. The intervention band of the National Bank should be extended from the present level. In a system with a wider intervention band, where the central bank would intervene only on the upper and lower intervention limits, while retaining the right of intervention within the band, commercial banks would have less opportunity for obtaining safe profits from arbitrage. On the other hand, forward transactions would increase in importance and forward exchange rates themselves could increasingly be used as indicators. However, if covered interest rate parity fully prevails, forward exchange premiums may never provide other information than interest rate differentials. In this case only the open position and turnover of forward foreign exchange markets will be of importance.

Monetary and Credit Aggregates

Although the exchange rate has become a major factor in determining the domestic price level, domestic credit expansion has been used by the NBH for years as an intermediate target/instrument to attain the targeted external current account position. The reason behind this was that in an open economy under a pegged but adjustable exchange rate system, the surplus money created by credit expansion eliminates itself inevitably through the deterioration of the external position. Suppressing the domestic credit expansion as a monetary policy objective lost its urgency at the end of 1991. In the course of 1992, the increasing number of bankruptcies accompanying economic recession, on the one hand, and the growing cautiousness of commercial banks to provide new credits (enforced also by the new banking law) on the other hand, led to a much smaller domestic credit expansion than was envisaged. However, the domestic credit restraint was also made possible by the capital inflows associated with the external current account surplus in 1991 and 1992. The resulting sharply increased liquidity in the banking sector was utilized by the budget to finance its growing deficit from domestic savings, while at the same time the external balance improved, too.

This exceptional situation ceased to exist by the second half of 1993. Since that time, the demand for enterprise credits has not decreased any further; rather it has begun to increase, while the government financing requirement remained high. Under the circumstances, more attention is paid now to domestic credit expansion and to the share of the enterprise sector and the budget, respectively.

The increased openness of the Hungarian economy is not reflected only in the liberalization of foreign trade but is also manifest in explicit or implicit ways in almost every item of the balance of payments (e.g., direct foreign borrowing by nonfinancial enterprises and commercial banks). It is perhaps less obvious but perceptible that the current account items of the balance of payments are also sensitive to interest rate differentials and exchange rate expectations. For example, low real domestic interest rates and devaluation expectations encourage early settlement of import purchases and postponement of exports. Equally, such conditions may induce capital flight through both over-invoicing and under-invoicing. Therefore, the visible trade balance reflects the effects of interest rate and exchange rate policy on capital movements; the authorities may not be able to record accurately the trade flows and may overestimate the current account deficit.

Under these circumstances, the NBH should control its own domestic assets on the basis of its forecasts of the demand for money and the monetary base, taking into account changes in the money multiplier, as determined by effects of financial innovations and other structural and institutional changes that characterize Hungary’s transition to a market-based economy (see Charts 79). The establishment of a monetary policy program should start from a forecast of the demand for money, calculated on the basis of expected real growth of the gross domestic product (GDP) and inflationary expectations. The forecast should also deal with the expected ratio of monetary and nonmonetary financing of the budget deficit, as well as changes in the effective reserve requirement ratio and the demand for cash in circulation. Possible changes in the monetary base and the permissible level of the central bank’s domestic credit placements can be derived from these factors, taking into account the limits of external financing. The demand for money may increase more or less than originally predicted and the other factors mentioned above may also affect the monetary base. Therefore, the required value of the intermediate target may have to be adjusted in the course of the year.

Chart 7.Real Interest Rate1, Current Account, and Trade Balance, 1990–93

1 Yield on the 90-day treasury bill deflated by the consumer price index.

Chart 8.Quarterly Percentage Change of Broad Money and Domestic Credit and Quarterly Current Account Balance

Chart 9.Monetary Base in Forint With and Without the Foreign Exchange Deposits of Commercial Banks at the National Bank of Hungary, 1990–93

(In billions of forint, last day of month)

It is becoming increasingly important to make a distinction in the analysis between the aggregate and the forint-denominated monetary base. When commercial banks resort to the central bank’s refinancing through currency swaps, in many cases foreign-currency deposits of the commercial banks held at the central bank turn temporarily into forint-denominated liquidity. In contrast to repurchase agreements, this does not change the whole monetary base but increases commercial banks’ forint-denominated liquidity. Therefore, it seems inevitable to distinguish between the monetary bases calculated by using different methods, as well as to monitor the National Bank’s net external liabilities and foreign exchange reserve position.

The basic argument for declaring the central bank’s net domestic assets as an intermediate target is that, under a fixed exchange rate, the National Bank’s net external position can be influenced most directly through this target. The necessary data for basing monetary policy on these operational, quantitative variables are available with adequate frequency and relatively little delay. Summaries on open market operations, which fundamentally determine the monetary base, can be calculated even several times a day, which may prove to be important in times of urgency.

Determination of Interest Rates

Of course, the above described framework for monetary policy does not allow the central bank to pursue interest rate policy objectives as well. With a pegged exchange rate, the increasing openness of the economy narrows interest rate policy’s room to maneuver. In 1994, the expected higher level of domestic real interest rates will be an additional factor attracting private domestic and foreign funds. This level of real interest rates is, however, not just a question of demand for, and supply of, debt instruments. Nominal and real interest rates are expected to be influenced increasingly by the risk premium, if foreign investors are to enter Hungarian loan and bond markets. (Prior to 1994, foreigners were not allowed to invest in government debt instruments.)

The NBH will focus increasingly on quantitative targets in the conduct of monetary policy in 1994 and later on. Such a policy shift may lead to highly variable interest rates—a consequence that may prompt the central bank to invent safety instruments to prevent excess instability in interest rates. However, an important experience Hungary had to learn in 1993 was that it should be careful in setting interest rate policy objectives—partly because under an interest rate policy regime the central bank may distort interest rate movements in financial markets by means of its own interventions and also because in pursuing interest rate policies, monetary authorities will have to accept that quantitative indicators are determined independently of their intentions. Moreover, if interest rate targets cannot be achieved and there comes a sudden change in monetary policy, then the credibility of monetary policy may be impaired. Finally, as suggested below, high and volatile interest rates can adversely affect the budgetary stance in view of the large government debt burden.

Budget Deficit Financing

Monetary processes in Hungary cannot be understood without reference to financing the budgetary deficit. The overall government debt exceeds 80 percent of the GDP (mostly external debt but also a growing proportion of internal debt). Since the enactment of the Act on the Central Bank (1991), its financing has been largely market based. The NBH can finance the budget deficit up to a given percentage (at the start 5 percent, later 4 percent, then 3 percent) of total budgetary revenues. There is a Hungarian specialty in institutional roles: external public borrowing is executed not by the Ministry of Finance but through the central bank; the NBH is, as sovereign borrower, the agent for the Government of Hungary. Thus in years when domestic savings are not enough to cover the domestic financing requirement, only the NBH can borrow, but there are limits on passing the loans to the budget. Since in the course of 1993 the central budget had problems in financing its deficit in the domestic financial markets, the budget approved by Parliament for 1994 set a direct financing target for the NBH of up to Hungarian Ft 80 billion, which corresponds to more than 6 percent of projected budget revenues.

Experience from the end of 1993 revealed a situation that turned out to be problematic: the maturities (1, 2, 6 and 12 months) of the present refinancing instruments (repos and swaps) correspond to the maturity structure applied in the financing of the budget deficit by discount treasury bills. This means that a certain relationship between the quoted repo interest rates and yields on newly issued treasury notes may result in an implicit financing of the budget deficit by the central bank, which would not violate the Act on the Central Bank. Yet, it can be argued that, to a certain extent, control over the monetary base and the expansion of the National Bank’s domestic placements might be eroded. In addition, the NBH may become exposed to political pressure to keep interest rates at a relatively low level. This is why the NBH is to rearrange maturities in order to avoid strict correspondence with treasury-bill auctions (see Charts 10 and 11).

Chart 10.Thirty-Day Treasury Bill Yields and One-Month Repurchase Rates

(In percent)

1 The tic marks represent two-week intervals from January 6, 1993 to March 30, 1994.

Chart 11.Outstanding Repurchases

(In billions of Hungarian forint)

1 The tic marks represent 20-day intervals from January 1, 1993 to March 30, 1994.

The NBH will engage in short-term repos with maturities of one day (overnight) or one week. The rate of interest payable on these short-term refinancing loans will function as an upper limit for interbank money market interest rates. Therefore, the posted interest rate on short-term repos should be determined from the beginning in such a way that it can assume this role. On the other hand, the utilization of short-term repos should not be tied to certain maturities, as this facility is available to banks in any amount and for any period of time.

In 1994, interest rates on repos with maturities of one or three months will be determined by regular tenders of interest rates, instead of permanent quotation of interest rates, and in accordance with maturities. This would help to control the growth in the repo stock in line with the targeted expansion of the National Bank’s net domestic assets. In this manner, this growth can be fully controlled by the Bank through the acceptance or rejection of interest rate offers made in the tenders. In 1993 the NBH quoted interest rates for reverse repo agreements with maturities of 1, 3, 6, and 12 months, but it did not offer interest-bearing facilities with maturities of less than one month. For tactical reasons the rates were set very low at the beginning of 1993, but even after some percentage point rises (the one-month reverse repo facility being offered for 5 percent early 1993 and for 18 percent at year-end), the banks did not make any use of the reverse repos. In early 1994 a one-week reverse repo facility was introduced, aimed at dampening large fluctuations of the interbank rate.

Currency swaps play the same role in the NBH’s refinancing operations as repurchase agreements, with the distinction that currency swap transactions are not available for a period of less than a month. The opportunity of using currency swaps will be maintained for a period of one to three months under the specification that their implicit interest rate conditions will always align with the interest rates established on the last repo tenders or posted repo rates (see Chart 12).

Chart 12.Monthly Stock of Foreign Exchange Swaps, 1993–94

(In billions of Hungarian forint)

1 The tic marks represent the last day of each month.

These objectives and the above-mentioned set of instruments should allow monetary policy to exercise an increasingly effective control over Hungary’s central bank’s assets. In the short run (i.e., for instruments with maturities ranging from one day to one month), changes in money market interest rates can be influenced, while movements in interest rates on instruments with maturities of more than one month will depend more on the short-term financing needs of the budget. As for instruments with maturities ranging between one month and one year, the NBH would eventually not apply permanent quotation of interest rates but make interest rates dependent on the required quantitative changes on tenders of repos. Thus, at the short end of the yield curve, there will be direct fixing of the interest rates; at the longer end, quantitative objectives will be set.

The Ministry of Finance is encouraged to lengthen the average maturity of the instruments financing the deficit. At the end of 1993 the financing of the current deficit was relying too much on discount treasury bills with maturities of 30 and 90 days. Paradoxically, the lengthening of the above maturities could only be achieved if returns on these short-term financing instruments increased substantially while returns on longer-term instruments grew less intensely. This would strengthen expectations of decreases in inflation and nominal interest rates, which would in the end increase demand for longer-term government securities (in the beginning, inevitably along an inverse yield curve).


In an economy where macroeconomic stabilization and deep structural changes go together, monetary authorities cannot rely on a single intermediate or ultimate objective: the central bank has to pursue pragmatically multiple targets. Authorities can thus take into account perceived changes in the transmission mechanism of monetary policy. However logical it is to start from a full policy discretion stand, later on the monetary authorities will have to sacrifice a considerable part of their monetary independence in order to provide clear signals regarding policy intentions through intermediate targets.

Intermediate targets must not be moving ones. In a time of profound and sometimes erratic change in the relationship between monetary variables—when velocity of money, propensity to save, and demand for money are unstable and when there are shifts in private portfolio preferences—the central bank should not hold to predetermined targets. This is not a phase of fine-tuning; revisions of goals and instruments are needed, if possible, without sacrificing credibility and clarity.

However, modern instruments of monetary policy have to be created and put into practice, including market-based financing of public debt (both primary and secondary markets), a liberalized regime of interest rates (removal of interest rate ceilings and credit rationing), active and passive repos (reverse repos) or other vehicles of open market operations, currency swaps, an interbank foreign exchange market, and current account convertibility.

In the presence of a sizable public debt and recurrent budgetary deficits, it is imperative to coordinate fiscal and monetary policies. Monetary policy cannot carry the full burden of correcting macroeconomic imbalances.

The author thanks Werner Riecke, George Kopits, and György Szapáry for helpful comments on an earlier draft of this paper.

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