The conduct and instruments of monetary policy June 2005

Outline of the presentation Short history of the MNB Objectives and task of the MNB Inflation targeting Transmission mechanisms Instruments of monetary policy

Short history of the MNB Magyar Nemzeti Bank (Hungarian National Bank, 1924) Lost of independence during WWII, obligation to finance the budget, hyperinflation One-tier banking system, no independence from the government in the command economy Two-tier banking system from 1987, rebuilding the traditional central bank functions From 1991 independent MNB, autonomous monetary policy Independence is crucial because - price stability is optimal for the whole economy in the long run - fiscal policy frequently concentrates on short term targets

Goals and functions of MNB (MNB act) Primary goal: achieve and maintain price stability Without jeopardising the primary goal, the MNB supports the economic policy of the Government Functions Conduct monetary policy in favour of price stability Maintain the stability of the financial system Issue of currency (banknote and coins) Operate the payment and settlement systems Hold and manage foreign exchange reserves (€13bn) Collect and provide statistical information (on monetary aggregates, BOP, exchange rates, interest rates, etc.)

Monetary policy The most efficient way the MNB can contribute to overall economic policy goals is price stability Apply monetary policy instruments to achieve the operative/intermediate targets and the ultimate goal MP instruments: forint and FX market transactions made by the MNB

Monetary policy goals in the inflation targeting framework Ultimate goal –price stability : inflation around 3% –inflation target for % +/-1% ,5% +/-1% Intermediate target –inflation forecast should be close to target –latest is 3,3% for 2005 and 3,2% for 2006 Operative target –Influencing short term (maturity of 3-6 months) money market interest rates –Through the changes of interest rates, FX rates and expectations on these the expected inflation is likely to be on target

Role of the inflation forecast Monetary Council decides on the key policy rate Rule of thumb if the inflation forecast is above the target  increase the rate below the target  decrease the rate around the target  rates on hold Inflation forecast 2 years ahead –„Report on Inflation”, quarterly –current forecast horizon: end of 2006 –Conditional forecast

Money market instruments of monetary policy Excess liquidity of banking system –Banks have more liquid assets than needed to fulfil the reserve requirements Reasons of excess liquidity –Intervention at the strong edge of the exchange rate band before 2001 (crawling band regime) –Treasury issuance of FX bonds, converted at the MNB Consequences –The excess liquidity is sterilize by deposit facility –The key policy instrument is therefore deposit, not loan (ECB)

Sterilization amounts

Main policy instrument Key policy rate (base rate) –rate on the 2-week deposit facility Characteristics of the 2-week deposit: –weekly standing facility –no limit on banks Indirect effect on short term market interest rates (operative target) Signalling effect –changes of the key policy rate signal future central bank behaviour and thus influence the expectations of market participants

O/N interest rate corridor The corridor is defined by the rates on the overnight credit and deposit facilities Objective: smooth the volatility of very short term (typically o/n) inter-bank rates so as to limit unwarranted fluctuations of the operational target The o/n inter-bank rates normally fluctuate inside the corridor, rates may break out of the corridor only in exceptional liquidity situations and only for a short time

Overnight interest rate corridor and the market rate

Reserve requirements Definition: Banks must deposit a fixed percentage (reserve ratio) of their liabilities with the central bank Objective: smooth inter-bank rates Reserve base: liabilities with maturity lower than 2 years Reserve requirement reserve base × reserve ratio (5%) Averaging mechanism: reserve requirements must be met on average during 1 month periods

Other money market instruments Tender, quick-tender: in the event of major short term liquidity shock –seldom-used instrument (November 2001, 1-week variable rate deposit quick-tender) Open market operations: outright purchase or sell of Government securities in the secondary market –lately used only during severe market turmoils (November 2003, purchase of government securities)

FX market instruments At the margin intervention in the FX market, standing facility –At the strong (weak) edge of the band the MNB is obliged to buy (sell) foreign exchange in unlimited amounts to prevent further strengthening (weakening) of the exchange rate Intra-marginal intervention, on the MNB’s own initiative Verbal intervention –Central bank statements to influence market expectations and thus the exchange rate –Efficient in the case of credible monetary policy

HUF/EUR in the FX rate band