What is MNB catching up to?

EM Research EM Briefing Hungary Why MNB cut rates today 22 March 2016 The Hungarian central bank played a master stroke today, lowering inflation forecasts sharply and cutting rates in response to inflation surprises having overtaken it over the past quarter. Having earlier signalled that further monetary easing would be done mainly using unconventional tools, it would have been only too easy for the CenBank to have got stuck in with such a view instead, the CB changed its signalling quite quickly, and then followed up with actual rate cuts even before the consensus had fully appreciated that rate cuts were coming this will likely also boost the efficacy of the policy. But, crucially, the CB averted falling seriously behind the curve. We don t always see central banks reacting this promptly. MNB lowered its base rate today by 15bp from 1.35% to 1.2%, lowered the deposit rate on its overnight deposits to -5%, and also reduced the interest rate on its overnight collateralised loan facility from 75bps above base rate to 25bps above base rate in effect lowering the upper-limit of its rate corridor from 2.1% to 1.45%. These moves will have an immediate impact of lowering market interest rates across the spectrum. The negative deposit rate, in particular, is a response to the ECB s recent depo rate cut. MNB does not want the HUF to strengthen from short-term intra-eu capital inflows. MNB backed the moves by sharply cutting its 2016 CPI forecast from 1.7% to 0.3% and the 2017 forecast from 2.6% to 2.4%. The bank now does not anticipate meeting the inflation target before well into 2018. Why did MNB make these changes today? The underlying rationale had been building up for some time: as chart 1 shows, the CB has had to continually revise lower its 2016 inflation forecast. Even after such revisions, the risks are to the downside: as chart 2 shows, inflation surprises, calculated using consensus expectations, have been significantly negative even in recent months. In our recent report Hungary - Why we expect further monetary easing of 1 February, we laid down the factors which we thought would prompt MNB to resume cutting rates. Among these were three main arguments, besides just the low inflation argument: 1) Growth is likely to decelerate, 2) MNB s QE may not depress yields by as much as imagined, and 3) MNB would not want its rate differential vs. the ECB to widen out. On the next page, we touch on these points. We see EUR-HUF higher at around 320 levels in the coming months. CHART 1: MNB has revised down inflation forecasts steadily over the past year Cumulative change in the 2016 core inflation forecast, in pps -0.2-0.4-0.6-0.8-1.0-1.2-1.4 2015 Q1 2015 Q2 2015 Q3 2015 Q4 2016 Q1 Source: MNB, Commerzbank Research CHART 2: Inflation freshly surprising to the downside Cumulative surprises: CPI vs. policy rate movements, pps 1 0.1 0-0.1-0.2-1 -0.3-2 -0.4-0.5-3 -0.6-0.7-4 -0.8 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 CPI (ls) Policy rate (rs) Source: Bloomberg, Commerzbank Research For important disclosure information please see page 5. research.commerzbank.com / Bloomberg: CBKR / Research APP available Analyst Tatha Ghose +44207 4758399 tatha.ghose@commerzbank.com

CHART 3: Hungary s real interest rate reached bottom in 2013 Policy interest rate minus core inflation rate, MNB vs. ECB, in pps 5 4 3 2 1 0-1 -2 2010 2011 2012 2013 2014 2015 2016 MNB Source: EC, Eurostat, Commerzbank Research ECB CHART 4: Hungarian yield curve not much flatter than those of peers Local 3y-10y spread for Hungary and 2y-10y spread for Poland, pps 2.5 2.0 1.5 1.0 0.5-0.5 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Hungary Source: NBH, Commerzbank Research Poland What is MNB catching up to? On the major elements of the macroeconomic outlook, the CB is very optimistic about domestic demand and has, in fact, raised its 2016 GDP growth forecast from 2.5% to 2.8%; we are more conservative with our 2.2% forecast. This difference arises because of our sub-consensus forecast for the German economy, where we continue to see risks from global demand softening. Secondly, EU fund inflows, which had contributed significantly to Hungarian growth last year, will pause this year. We also note that consumer confidence has stopped improving in Hungary. Nevertheless, this is not an area of serious divergence of opinion: MNB appears to have taken on board that stable demand and wage growth is not passing on to broader inflation in today s world. MNB has let go of the textbook view that stable domestic demand will gradually bring inflation back to target, and is instead focussing on the hard data on inflation and FX trends. The second macroeconomic pillar, of course, is inflation: we do not have the revised core inflation forecast yet; but, we assume that MNB has lowered it commensurately too, perhaps to 2% from 2.4%. It would take serious upward inflation dynamic for the core inflation rate, which is running at 1.5%, to accelerate and average 2% for 2016, let alone 2.4%. In fact, the steady downward revisions MNB has had to make to this forecast over the past year (see chart 1) tells a broader story about low headline inflation seeping through to core categories. MNB s language today appeared to fully take this on board when it did not pin the entire forecast change on temporary commodity price effects. Finally, MNB could have held on to rates today and opted just to expand the size of its QE tenders, which would be consistent with its earlier promise to use QE as the main policy tool. But, as chart 4 shows, the QE operations have had only a mild effect on Hungary s yield curve. This is not immediately obvious because the slope of the local bond curve has been stable after all. Nevertheless, when comparing with a peer such as Poland, which is not operating long-end yield capping QE, the added advantage for Hungary is difficult to see. Hungary did outperform Poland for much of Q1 2016, but that was because of the Polish curve steeping on idiosyncratic political risk. Hence, interest rate swap tenders have not been a compelling substitute for base rate cuts, especially when the base rate itself is still high by regional standards. If the base rate has to drop to zero over the coming year, QE will anyway have to take over but, there is not much rationale to use the tools in reverse order. Policy conclusions We expect MNB to cut the base rate again by 15bp in April, taking it to 1.05%. Our year-end forecast for the rate is 1%, but the risk is clearly to the downside. We will revisit our forecast soon. We do not rule out the base rate declining even to zero but, this would be contingent upon further ECB easing and also negative interest rates adopted by peers such as the Czech Republic, which cannot yet be taken for granted. 2 22 March 2016

In conclusion, today s move by MNB was pro-active rather than reactive. True, the ECB had eased recently. But neither had the HUF strengthened too much since then, nor was it so obvious that the old story of inflation gradually returning to target on its own had become untenable there was no market pressure for MNB to urgently break its status quo. Rather, as chart 2 nicely summarises, the CB was beginning to fall behind with its policy relative to inflation surprises, but has caught up with one sharp move. 3 22 March 2016

Emerging Markets Forecasts Summary Real GDP (%) Inflation (%) 2015E 2016F 2017F 2015F 2016F 2017F Asia China 6.9 6.3 5.8 1.4 1.5 2.0 India 7.0 7.0 6.1 4.9 5.0 5.3 South Korea 2.6 2.8 2.9 0.7 1.5 2.0 Indonesia 4.8 5.6 6.0 6.4 4.0 4.0 Thailand 2.9 4.0 4.2-0.9 0.1 0.8 Malaysia 4.9 5.2 5.4 2.1 2.4 2.5 EMEA Poland 3.6 3.1 3.2-0.9-0.7 1.7 Czech Republic 4.2 2.2 2.8 0.3 0.5 1.7 Hungary 3.0 2.2 2.6-0.1 1.0 2.5 Turkey 4.1 4.2 3.2 7.7 7.9 8.8 Russia -3.6-2.5 1.3 15.6 10.8 10.1 South Africa 1.3 0.9 1.5 4.6 6.4 7.0 LatAm Brazil -3.8-2.5 1.3 9.0 10.3 9.3 Mexico 2.5 3.1 3.5 2.7 2.5 2.7 Colombia 3.1 2.9 3.5 5.0 3.8 3.2 Chile 2.1 3.2 3.3 4.3 3.4 2.0 Quarter-end 22/03/2016 Q2 16 Q3 16 Q4 16 Q1 17 Q2 17 China Policy Rate 4.35 4.10 4.10 4.10 4.10 4.10 3M 2.80 2.90 2.90 2.90 2.90 2.90 10Y 2.88 2.80 2.80 2.80 2.80 2.80 USD/CNY 6.50 6.70 6.80 6.90 6.90 6.90 India Policy Rate 6.75 6.25 6.00 5.75 5.50 5.50 3M 7.80 7.20 7.10 7.00 6.90 6.80 10Y 7.50 7.40 7.30 7.20 7.10 7.00 USD/INR 66.78 68.00 68.50 69.00 69.00 69.50 Poland Policy Rate 1.50 1.50 1.00 1.00 1.00 1.00 3M 1.57 1.52 1.15 1.15 1.20 1.20 10Y 2.84 3.00 3.00 3.20 3.30 3.30 EUR/PLN 4.26 4.25 4.25 4.25 4.25 4.25 Czech Republic Policy Rate 5 5 5 5 5 5 3M 0.29 0.25 0.30 0.35 0.35 0.35 10Y 0.37 0.40 0.30 0.20 0.40 0.50 EUR/CZK 27.03 27.00 27.00 27.00 27.00 24.50 Hungary Policy Rate 1.35 1.00 1.00 1.00 1.00 1.00 3M 1.34 1.00 1.00 1.00 1.00 1.00 10Y 3.06 3.25 3.10 3.20 3.30 3.30 EUR/HUF 311.11 320 325.00 325.00 325.00 325.00 Turkey Policy Rate 7.50 7.50 7.50 7.50 7.50 7.50 3M 11.50 11.50 11.00 10.50 10.50 10.50 10Y 9.94 10.50 11.00 11.00 11.00 11.50 USD/TRY 2.88 3.15 3.20 3.25 3.30 3.40 Russia Policy Rate 11.00 11.00 11.00 11.00 11.00 11.00 3M 11.79 11.20 10.70 10.45 10.20 10 10Y 9.02 9.50 9.40 9.30 9.10 9.00 USD/RUB 68.07 76.00 80 82.00 82.00 84.00 Brazil Policy Rate 14.25 15.00 15.50 16.00 16.00 15.00 3M 14.10 15.10 15.60 16.10 16.20 15.20 10Y 14.25 16.50 17.00 17.50 17.00 16.00 USD/BRL 3.62 4.10 4.20 4.30 4.40 4.50 Mexico Policy Rate 3.75 3.75 4.00 4.00 4.00 4.25 3M 3.87 3.60 3.60 4.00 4.20 4.70 10Y 6.00 6.20 6.20 6.25 6.30 6.40 USD/MXN 17.49 17.50 17.50 17.50 17.25 17.25 Source: Bloomberg, Commerzbank Research 4 22 March 2016

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