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October 25, 2006

Central Europe Takes A Breather, But The Sense Of Calm Is Unlikely To Last
by Victoria Marklew

As expected, the National Bank of Hungary (NBH) hiked its policy interest rate again today, but in contrast with last month the NBH is likely to be the only one of the big-four central Europeans to tighten in October, as inflation and political woes take a breather.

Today's 25bp rate hike - taking the base rate up to 8.00% - was the fifth consecutive monthly increase in Hungary, but a more cautious move than the 50bp increases of the previous three months. NBH Governor Jarai stated that the policymakers opted for a smaller increase because there had already been a significant level of tightening. He also acknowledged that the market sees PM Gyurcsany's position as having firmed (the beleaguered PM won a parliamentary confidence vote on October 6), and that the probability of the government's fiscal reforms being implemented has improved.

The Governor also stated that today's rate hike should not be seen as an indicator of future action: "We want to give no indication at all about the next rate decision." This seems to be an attempt to warn the market that rates may be on hold in November - reflecting the possibility that lower global oil prices and a stronger forint will convince the NBH to pause - but it is highly unlikely that today's move marks the peak of this rate cycle. Headline inflation jumped to 5.9% on the year in September, its highest in almost two years, thanks in large part to VAT and excise tax increases that are part of the government's fiscal reform package. Utility price increases also took effect last month and additional tax hikes will kick in next year.

Yesterday saw violent clashes in Budapest as opponents of the government took advantage of the official celebrations of the 1956 Hungarian uprising against Soviet rule to call for the government to step down. The ruling coalition of Socialists and Free Democrats continues to support Gyurcsany, but some of the anti-government protests are taking an increasingly violent tone, with extremist right wing groups and neo-Nazi symbols much in evidence yesterday. In addition, some members of the Fidesz opposition party continue to call for using extra-parliamentary means to undermine the PM. The government is likely to remain in power, but the political scene in Hungary will remain volatile for the next few months.

In neighboring Poland, the previous month's political crisis has passed, and inflation remains under control, making it highly likely that the central bank will continue to hold interest rates at its meeting tomorrow (October 25). However, the sense of political calm is likely to prove short-lived. PM Kaczynski's Law and Justice Party has managed to avoid an early general election - in which the party and its allies would have fared badly - by re-forming the coalition with the nationalist League of Polish Families and the populist Self Defense. Given the bad blood that now exists between these three (Kaczynski kicked Self Defense out of the government in late September) and the fact that defections from Self Defense have cut the coalition's parliamentary majority, renewed squabbling can be expected.

With the annual rate of headline inflation unchanged last month at 1.6%, there is little obvious pressure on the National Bank of Poland (NBP) to tighten. However, some members of the 10-member policy council have begun to call for a pre-emptive tightening to counter an expected jump in inflation next year, with wages and employment both rising and the zloty likely to be weakened by renewed political turmoil. Although the majority appear to be more sanguine, the overall policy stance is likely to become more hawkish through the end of this year. An early indication of this may come with the NBH's latest quarterly inflation projection, due to be released Thursday (26th).

The Czech National Bank (CNB) is also poised to release its updated quarterly inflation and growth forecast on Thursday, the date for its next policy meeting. Having hiked by 25bp in July and again in September, the CNB is likely to leave its policy rate unchanged this week at 2.50%. Headline inflation dropped to an annual rate of 2.7% in September, below the bank's 3.0% target, and will probably ease further this month and next thanks to lower natural gas prices. Nevertheless, with domestic demand continuing to accelerate and ongoing political uncertainty likely to weigh on the crown and on the budget outlook, the overall policy stance will remain hawkish at least into early 2007.

After its surprise 25bp rate hike last month, it is not clear whether the Slovak central bank will feel comfortable enough to leave its two-week repo rate unchanged at 4.75% when it meets on October 31. Governor Sramko continues to highlight the need to tighten, and headline inflation climbed to 4.5% on the year in September. It's possible that the Slovak crown's resurgence over the past couple of weeks, which took it to an all-time high against the euro, will convince the policymakers to wait-and-see for a month. The currency has been buoyed by parliament's approval of the draft budget for 2007 - which is more fiscally responsible than expected from the leftist coalition elected in June - and by last week's sovereign rating upgrade from Moody's (to A1). Even if the bank does pause, its overall stance will remain hawkish.

All told, both the markets and the politics of central Europe are looking a little calmer than this time last month (see September 29 Daily Global Commentary: Central Europe's Central Banks Respond to Deteriorating Inflation and Fiscal Outlooks). However, with ongoing protests in Hungary, the probability of renewed political woes in Poland by the new year, and expectations that inflation will resume its upward march in the coming months, this sense of improved regional sentiment is unlikely to last.

Victoria Marklew
The Northern Trust Company
Economic Research Department
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

Copyright © 2005-2008 The Northern Trust Company

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