The ultimate objective of economic policy as a whole is to ensure the conditions necessary to achieve balanced, long-term sustainable economic growth. A central bank can serve this goal best by keeping inflation low and stable through the conduct of predictable and credible monetary policy.
This is what also underlies the Central Bank Act, which provides that ‘the primary objective of the MNB shall be to achieve and maintain price stability’, in line with growing international practice as well as European Union legislation.
There is general consensus in both economic theory and the international practice of central banking that monetary policy instruments alone are insufficient to exert a lasting influence on both the rate of economic growth and employment. Although a temporary impact cannot be ruled out over the short term, monetary policy can only affect nominal variables such as inflation and the nominal interest rates over the longer term. The underlying reason for this is that inflation expectations will, over time, adjust to a changed environment.
Inflation may do serious damage to the economy via two interrelated channels. One is that higher inflation increases ‘menu’ costs and ‘shoe-leather’ costs and leads to diverse forms of distortion in the economy, e.g. in the tax regime and the accounting system. Higher inflation implies higher nominal interest rates and, consequently, higher amounts of loan repayments for borrowers when measured against disposable income. This, in turn, leads to shorter loan maturities and thus to a decrease in the depth of financial markets.
Another is that high and variable inflation interferes with the information content of prices, which is the very foundation of a healthy market economy. As a consequence, assessments of changes in demand and supply become distorted, thereby impeding the efficient use of resources. Furthermore, volatile inflation may lead to an unintended redistribution of incomes. Another problem is that uncertainty over inflation entails the shortening of contract terms, which is adverse for economic activity. The fact that the two channels reinforce each other adds to the costs of inflation, as higher inflation usually leads to wider fluctuations and increases inflation uncertainty.
Realising the limitations of monetary policy’s impact on the real economy as well as the costs of inflation, developed economies and an increasingly large number of emerging countries define price stability as the ultimate objective of monetary policy. Price stability is defined as low, but not zero, inflation, explained by downward nominal rigidities, the risk of deflation, the need for positive nominal interest rates and statistical measurement errors in the consumer price index. Based on these considerations, price stability is set at around 2%–3% by the majority of central banks of countries with inflation targeting regimes, while the European Central Bank (ECB) defines it as ‘below, but close to 2%’.
The MNB set, with effect from 2007, an average 3% increase in consumer prices as its medium-term inflation target consistent with price stability. The Bank’s inflation target is in line with international practice, but is slightly higher than the level of inflation defined by the ECB as consistent with price stability. The reason for this difference lies in the catching-up process of the Hungarian economy, which is accompanied by a wider gap between tradables and non-tradables inflation. However, it may be justified to reduce the medium-term inflation target as the convergence process moves forward. Lowering the inflation target may also be made necessary by Hungary’s intention to join the euro area. Over the longer term, the inflation target may be reduced to around 2%, a level consistent with the ECB’s definition of price stability.