Past the peak of the inflation and interest rate cycle

HUNGARY - Report 24 May 2023 by Istvan Racz

Following a peak in January and roughly unchanged levels in the rest of Q1, CPI-inflation fell materially in April at last. This new pace of downward movement is likely to become a trend in the next two months and to accelerate further in Q3. We still believe that single-digit inflation by December will be manageable, although not at all easy to reach, even though energy import prices appear to be increasingly supportive.

Encouraged by the initial disinflation, the MNB reduced its sterilization rate by 100 bps at the Council’s late-May meeting. We expected this step for June only, but the average of analysts and market players did not appear surprised at all, and they had a point. Commenting on the measure, the Bank spoke of its intention to continue sterilization rate cuts, moving towards the unchanged base rate gradually. They stressed the wish to make real interest rates positive by end-2023. On this basis, we still expect the sterilization rate on the current level of the base rate in December.

The price for rapid disinflation is likely to be a weak economy this year. Data for Q1 are pointing exactly in this direction. Weak output and demand will test the endurance of political decision-makers. Yet we are increasingly of the view that the MNB will not be seriously pressured to loosen policy prematurely, as politics keeps insisting on its inflation target, and as the widespread expectation remains that rapid disinflation will cause domestic demand to recover in H2.

The balance of payments is widely expected to be moving in the right direction this year, with the consequence of the forint needing less support from the high sterilization rate than just a few months ago. As energy prices are falling, Hungary enjoys improving terms of trade, and its trade account moved back into surplus in Q1. But for now, the overall BOP picture is not quite as positive as this, because of growing expenditure of investment income, decreasing transfers from the EU, a growing errors and omissions gap and disappointing FDI flows so far this year.

Fiscal policy remains in a pincer between the need to reduce the deficit, the negative impact of the weak economy on its revenue, and the lack of new EU funds. Expenditure controls are generally very tough, but the need to settle the deferred losses of last year’s energy subsidies is still a significant burden. This year’s ambitious deficit target is unlikely to be met, but we still expect the deficit and debt ratios to fall moderately from 2022.

Parliament has approved a batch of important judicial reforms, laying the grounds for the release of almost half of currently blocked development grants from the EU. However, strong political headwinds and bureaucratic inertia, aggravated by Hungary’s aggressive behavior in the EU, are likely to cause further delays in Hungary's getting access to those funds, which is thus unlikely to happen before the end of this year.

In another piece of bad news, Fitch Ratings has said recently that it still sees a downgrade risk for Hungary. Following a change in the outlook for its BBB sovereign rating from Stable to Negative earlier this year, Fitch will have another review date for this rating in late June. A downgrade on that occasion, the second one from a Top-3 agency since the start of 2023, cannot be ruled out.

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