The conduct and instruments of monetary policy

1. The conduct and instruments of monetary policy June 2005

2. Outline of the presentation • Short history of the MNB • Objectives and task of the MNB • Inflation targeting • Transmission mechanisms • Instruments of monetary policy

3. Short history of the MNB • Magyar Nemzeti Bank (Hungarian National Bank, 1924) • Lost of independence during WWII, obligation to finance the budget, hyperinflation • One-tier banking system, no independence from the government in the command economy • Two-tier banking system from 1987, rebuilding the traditional central bank functions • From 1991 independent MNB, autonomous monetary policy Independence is crucial because - price stability is optimal for the whole economy in the long run - fiscal policy frequently concentrates on short term targets

4. Goals and functions of MNB (MNB act) Primary goal: achieve and maintain price stability • Without jeopardising the primary goal, the MNB supports the economic policy of the Government Functions • Conduct monetary policy in favour of price stability • Maintain the stability of the financial system • Issue of currency (banknote and coins) • Operate the payment and settlement systems • Hold and manage foreign exchange reserves (€13bn) • Collect and provide statistical information (on monetary aggregates, BOP, exchange rates, interest rates, etc.)

5. Monetary policy • The most efficient way the MNB can contribute to overall economic policy goals is price stability • Apply monetary policy instruments to achieve the operative/intermediate targets and the ultimate goal • MP instruments: forint and FX market transactions made by the MNB

6. Monetary policy goals in the inflation targeting framework Ultimate goal • price stability : inflation around 3% • inflation target for 2005 4% +/-1% 2006 3,5% +/-1% Intermediate target • inflation forecast should be close to target • latest is 3,3% for 2005 and 3,2% for 2006 Operative target • Influencing short term (maturity of 3-6 months) money market interest rates • Through the changes of interest rates, FX rates and expectations on these the expected inflation is likely to be on target

7. Role of the inflation forecast • Monetary Council decides on the key policy rate • Rule of thumbif the inflation forecast is above the target  increase the rate below the target  decrease the rate around the target  rates on hold • Inflation forecast 2 years ahead • „Report on Inflation”, quarterly • current forecast horizon: end of 2006 • Conditional forecast

8. Money market instruments of monetary policy • Excess liquidity of banking system • Banks have more liquid assets than needed to fulfil the reserve requirements • Reasons of excess liquidity • Intervention at the strong edge of the exchange rate band before 2001 (crawling band regime) • Treasury issuance of FX bonds, converted at the MNB • Consequences • The excess liquidity is sterilize by deposit facility • The key policy instrument is therefore deposit, not loan (ECB)

9. Sterilization amounts

10. Main policy instrument • Key policy rate (base rate) • rate on the 2-week deposit facility • Characteristics of the 2-week deposit: • weekly standing facility • no limit on banks • Indirect effect on short term market interest rates (operative target) • Signalling effect • changes of the key policy rate signal future central bank behaviour and thus influence the expectations of market participants

11. O/N interest rate corridor • The corridor is defined by the rates on the overnight credit and deposit facilities • Objective: smooth the volatility of very short term (typically o/n) inter-bank rates so as to limit unwarranted fluctuations of the operational target • The o/n inter-bank rates normally fluctuate inside the corridor, rates may break out of the corridor only in exceptional liquidity situations and only for a short time

12. Overnight interest rate corridor and the market rate

13. Reserve requirements • Definition: Banks must deposit a fixed percentage (reserve ratio) of their liabilities with the central bank • Objective: smooth inter-bank rates • Reserve base: liabilities with maturity lower than 2 years • Reserve requirement reserve base × reserve ratio (5%) • Averaging mechanism: reserve requirements must be met on average during 1 month periods

14. Other money market instruments • Tender, quick-tender: in the event of major short term liquidity shock • seldom-used instrument(November 2001, 1-week variable rate deposit quick-tender) • Open market operations: outright purchase or sell of Government securities in the secondary market • lately used only during severe market turmoils (November 2003, purchase of government securities)

15. FX market instruments • At the margin intervention in the FX market, standing facility • At the strong (weak) edge of the band the MNB is obliged to buy (sell) foreign exchange in unlimited amounts to prevent further strengthening (weakening) of the exchange rate • Intra-marginal intervention, on the MNB’s own initiative • Verbal intervention • Central bank statements to influence market expectations and thus the exchange rate • Efficient in the case of credible monetary policy

16. HUF/EUR in the FX rate band