I think, the CB will keep the average funding cost close to the policy interest rate unless exchange rate changes unfavorably.

First, tax on selected goods and services and later fuel and diesel oil prices were raised. Yesterday, electricity and natural gas prices were increased by 10 percent. I addressed these developments in the context of stability and growth during Saturday’s commentary. Today, I want to evaluate these from the monetary policy perspective.

At the end of 2011, inflation rate was 10.5 percent. In August, inflation was recorded at 8.9 percent. The year-end target is 5 percent. The Central Bank’ (CB) year-end inflation forecast was 6.2 percent until recently. I am addressing these figures in order to draw a better picture of the price raises on electricity and natural gas. The prices of the two important inputs for both production and the services sector were raised at once, at a rate beyond the twelve-month inflation rate and twice the inflation target.

Price shock

Such price shocks are not new for us. We have witnessed similar shocks in the 1980s and 1990s as well. In this sense, there is nothing new under the sun, and this, is the problem. After all that we have experienced, why the “price updates” were not introduced in pieces over a longer time frame? After all, large price increases, especially for important inputs, might trigger hikes in costs of a number of goods and services and have the potential to push up inflation expectations. Finally after a long delay, a downwards pressure was put on inflation; but the latest actions caused a new wave of upwards pressure.

Concerning the latest interest rate decisions of the CB, here is the picture: as a person who attended Monetary Policy Committee (MPC) meetings several times, I can say that tax and price raises don’t come as a surprise to the CB. Therefore, the CB was most likely informed of the tax and price increases, if not up to the mark, before it lowered the upper limit of the interest rate corridor.

Now, let’s assess the picture from the CB’s perspective: first, the CB would evidently prefer a series of modest price increases extended over time over a price shock. However, it doesn’t have a control on the timing and magnitude of tax raises and price adjustments. Therefore, concerning economic stability, steps to facilitate budget discipline are better than inaction that might increase budget deficit. Second, the CB’s recent MPC meeting remarks have been drawing attention to global uncertainties and signaling that the Bank will respond with a “flexible” monetary policy. If a possible inflationary trend turns to become permanent, the CB has the chance to increase the average cost of lending to banks, keeping other interest rates constant, without clouding the outlook. By the way, I am just stating that this is an option for the CB. It doesn’t mean I would approve such a non-transparent intervention.

Nevertheless, I don’t think the CB will choose this path without a marked upper pressure on inflation, which brings me to the third point: the Bank will increasingly stress that the course of headline inflation is in line with the 2013 target (of course, if it doesn’t tend upwards, too) starting in November, if not immediately. It will draw attention to the weakness of domestic demand and state that exchange rate has not been suppressing costs. Therefore, I think, the CB will keep the average funding cost close to the policy interest rate unless exchange rate changes unfavorably. And as it becomes clearer that year-end inflation will remain around 7-8 percent, the CB might lower the upper limit of the interest rate corridor again, with an emphasis on the headline inflation. None of these estimations will apply if external conditions deteriorate or exchange rate shows signs of a hike, of course. But this should be dealt with a separate study.

This commentary was published in Radikal daily on 02.10.2012