This Selected Issues paper on Hungary presents an empirical analysis of the leading indicators for inflation and models the determinants of inflation. It summarizes current knowledge about the behavior of inflation and thus underpins the subsequent discussion of possible changes to the current nominal anchor framework. The paper analyzes the growth potential and fiscal issues affecting that potential, and the external constraint. The paper suggests that some relatively stable econometric relationships can be found, despite the considerable structural and policy changes that occurred during the 1990s.
1. Hungary has made substantial economic progress since transition began. In difficult circumstances, wholesale reform of institutional and corporate governance structures has been implemented. In addition, the large external imbalances that emerged in the mid-1990s have been corrected, the fall in output that marked the early stages of transition has been decisively reversed, and, during 1998, inflation fell rapidly towards single digits.
2. In this context, the challenge for policymakers, now, is to build on the improved economic performance already achieved, and thereby to lay the foundations for early accession into the European Union.
3. This Selected Economic Issues Paper addresses several topics related to this agenda. Chapters II–IV focus on the nominal anchor framework. The remaining chapters discuss growth potential and fiscal issues affecting that potential, and the external constraint. The standard section on exchange arrangements concludes the paper.
4. The discussion of the nominal anchor framework has several components. Chapter II presents an empirical analysis of the leading indicators for inflation and Chapter III models the determinants of inflation. This material summarizes current knowledge about the behavior of inflation and thus underpins the subsequent discussion of possible changes to the current nominal anchor framework.
5. Chapters II and III suggest that some relatively stable econometric relationships can be found, despite the considerable structural and policy changes that occurred during the 1990s. Stable leading indicators reported in Chapter II include producer and import prices, as well as nominal and real exchange rates. Interestingly, neither nominal wages nor nominal unit labor costs are leading indicators of inflation. This reason for this finding is suggested by the exercise in Chapter III, which models inflation directly. That exercise suggests that nominal wages adjust to recent inflation, rather than determining future inflation. It also suggests that real wages follow productivity closely as well as responding rapidly to labor market imbalances, both signs of sound labor markets.
6. Two key conclusions from these chapters are highlighted. First, the nominal exchange rate—a variable that the authorities have direct control over under the crawling–peg regime—is both a stable leading indicator of inflation and a key determinant of inflation. Second, the impact of changes in the nominal exchange rate on the real exchange rate is largely exhausted within two years, implying that inflation inertia is less pervasive than might be expected.
7. Accordingly, the risks of a real appreciation arising from a strengthening of the nominal exchange rate, while present, are offset in practice by a relatively rapid adjustment of prices to nominal exchange rate shocks. This empirical evidence may ease concerns that an accelerated exchange–rate led disinflation might put undue pressure on competitiveness and hence on the external accounts. But the evidence is qualified by the quality and the limited time–span of the data and by the structural changes that occurred in that period.
8. With this background, Chapter IV consists of a qualitative discussion of current issues in the design of the nominal anchor framework. In particular, it considers issues related to the appropriate speed of prospective disinflation, the exchange rate regime in that context and ahead of EU accession, and issues pertaining to the suitability of an inflation targeting approach for Hungary.
9. The discussion notes that the case for a gradual disinflation in Hungary rests on inflation inertia, given international evidence that speedy disinflation is commonly less costly in terms of lost output than gradual disinflation. It also suggests that in the medium–term, a widening of the exchange rate band could be appropriate, to react to evidence that capital flows into Hungary are becoming increasingly sensitive to yield differentials and to anticipate further capital inflows as EU accession approaches. In particular, a band widening would increase the flexibility of interest rate policy and diminish the need for sterilized intervention to prevent the forint from appreciating out of its current narrow band. But, the chapter also emphasizes that the case for such a step would also have to weigh the risks of an unsustainable real appreciation of the forint, within a wide band, if prices did not respond rapidly enough. Finally, it is noted that the promising results described in Chapters II and III, while preliminary, bode well for the introduction in the medium term of an inflation targeting framework in Hungary. Issues pertaining to a further strengthening of the legal independence of the central bank, which is already substantial, are also discussed.
10. Increased supply–side flexibility, while primarily aimed to further stimulate growth, would also contribute to an accelerated disinflation. The remaining chapters address these and related issues. Chapter V presents an exploratory analysis of the contribution of factor accumulation and total factor productivity growth to the behavior and prospects for output. The key conclusion is that if the latter is within norms achieved by European industrialized countries during their so–called “golden age” of growth in the 1950s and 1960s, growth rates of 5–6 percent would be achievable with fixed investment growing in real terms by around 7 percent. This would require, however, falling unemployment rates as well as increased labor force participation rates, and policy measures to ensure that productivity growth is strong.
11. Chapter VI considers a number of tax policy issues that impact on the strength of labor supply and productivity growth. In particular, it notes the high rate of taxation on labor and discusses both its short–and long–run macroeconomic effects. A key conclusion is that initiatives to substantially further reduce the burden of labor taxation, in order to stimulate employment and productivity growth, will require additional public expenditure reform to maintain a prudent fiscal balance. This is because most potential tax sources are already fully exploited.
12. Chapters VII and VIII consider the perennial issue of the external constraint in Hungary. This constraint has in the past been the first constraint on growth to bind and has also been a key concern in consideration of an accelerated exchange rate–led disinflation. Chapter VII reports the results of an exercise to model of the determinants of the trade balance empirically. The growth of domestic demand relative to trend, and a measure of cyclical external demand are found to be key determinants. The real exchange rate (measured by relative unit labor costs) also plays a role. An implication of these findings is that policy to slow domestic demand could offset the short–run impact of an accelerated exchange rate led disinflation on the external balance, to keep that balance within limits set by Hungary’s long–term intertemporal external financing constraint. Factors affecting that long–term constraint are discussed in Chapter VIII, which also presents a series of simulations to quantify the constraint. Chapter IX presents a brief summary of Hungary’s exchange arrangements and its capital control regime.