Hungary: Ten questions on monetary policy Q1: How does the NBH think about the inflation target The NBH targets inflation at 3%Y, over a time horizon of 5-8 quarters. A tolerance band of +/- 1pp around the target was introduced in March 2015. In the bank's view, inflation is and has always been the NBH's sole target, although the bank describes itself as a flexible inflation targeter: in other words, temporary deviations due to cost shocks or one-off impacts are ignored. Having a band gives the NBH a very wide mandate to interpret the target. Subject to the fulfillment of the inflation target, the bank can focus on financial stability and the economy. As we will see below, the bank's objectives in recent years went well beyond inflation targeting. Q2: What are the NBH's main policy objectives, apart from inflation In practice, the inflation backdrop has been very benign in Hungary since 2013. Over this period, headline CPI has averaged around 1%Y, and core inflation 2%Y. While this has not been unique to Hungary, low inflation has indeed allowed the NBH to adopt a broader view of its targets, and pursue an ever more experimental monetary policy, which in turn required an ever more complex toolkit. More specifically, with low inflation 'in the bag', the NBH moved its focus towards reviving credit growth (Funding for Growth, 2013); boosting domestic ownership of the bond market (Self-Financing Scheme, 2014); improving financial stability (FX mortgage conversion in HUF, 2014); detaching Bubor from the 'policy rate' using liquidity management (from 2016: 3m depo cap, O/N rate corridor, FX swaps); mortgage bond purchases (ongoing); and an IRS programme aimed at flattening the curve (ongoing). The list above is not exhaustive, but it shows clearly how the NBH's efforts have gone well beyond its narrow inflation target. The bank focused on boosting financial stability, but above all its efforts were on providing a growth-friendly policy backdrop, and loose policy. In the bank's mind, low underlying inflation suggested ample slack and made a very loose policy stance possible. A large C/A surplus and the removal of some key external vulnerabilities (e.g., household FX debt, large external debt) allowed the NBH to gain significant degrees of freedom in monetary policy setting. Such negative real rates would simply not have been sustainable in the days when Hungary was running a large C/A deficit and had high external funding needs. Q3: How have these objectives changed recently In late 2017, the NBH suggested that it was pursuing three objectives. First, to continue to keep policy loose at the front end, anchoring Bubor as close to zero as possible. Second, to use the IRS facility to flatten the yield curve versus peers. And third, to encourage the creation of fixed-rate loans. It is quite clear that the bank's range of objectives has narrowed since then. The creation of more fixed-term loans was quickly downgraded as a policy goal, and the increase in the share of loans with long periods of interest rate fixation disappeared from the2statement. More recently, the reference to relative curve flattening also disappeared from the statement, given the fact that the Hungarian curve has steepened of late under market pressure. Our view is that the NBH's key and only focus is on keeping low rates for as long as possible, compatible of course with its CPI target. In turn, this allows HUF to remain competitive (more on this below). Q4: How does the NBH think about the FX For Hungarian watchers, these have been years of constant changing and learning. But perhaps no change has been so profound as that of the NBH's attitude to HUF. Back in 2012, Hungary's FX sovereign debt was 50% of the total, household FX debt was over 20% of GDP and the FX pass-through was estimated at 25-30%. Right now, FX sovereign debt is a mere 20% of total, household FX debt has disappeared and the FX pass- through is around 10-15%. While a lower FX pass-through probably owes much to secular forces and is common to many other countries, a lower FX share of government debt was partly a result of the NBH's self-financing scheme, and the disappearance of household FX debt was also an initiative of the NBH. In other words, Hungary's overall FX sensitivity has fallen largely as a result of NBH initiatives. It is therefore by design, and not by accident, that the NBH can take a much more relaxed view of currency developments today compared to the past. The conclusion is that while the NBH is not indifferent to FX, it certainly is not as troubled by FX weakness as it was in the past. And for that reason we are highly sceptical of any notion that there is a 'line in the sand' anywhere near current EURHUF levels. Purely based on inflation-targeting purposes, at present probably any EURHUF rate up to the 345-350 area would still be consistent with the inflation target range. And in addition, the NBH – as any other central bank – cares about volatility and gappy moves. A gradually weakening currency probably does not pose any major concerns. Fast moves based on speculative bets would be more likely to elicit a response. Exhibit 1:Government debt FX share much lower than in the past... 15 20 25 30 35 40 45 50 55 Jan- 04 Jan- 05 Jan- 06 Jan- 07 Jan- 08 Jan- 09 Jan- 10 Jan- 11 Jan- 12 Jan- 13 Jan- 14 Jan- 15 Jan- 16 Jan- 17 Jan- 18 FX debt as a % of total debtNon-res ownership, % of total, HGBs Source: Haver Analytics, Morgan Stanley Research Exhibit 2:...and no FX vulnerability remains on the HH sideSource: Haver Analytics, Morgan Stanley Research3Q5: How does the NBH think about the ECB and other central banks In official rhetoric, the NBH has often suggested that it is influenced by the ECB. The ECB plans to halt asset purchases in December, which means that its effect on long-end rates in the euro area will be smaller. At the same time, the ECB plans to keep policy on hold at least until summer 2019. The NBH did not use the size of its balance sheet the way the ECB or other central banks did, and so it does not need to worry about scaling back the use of its balance sheet. However, the NBH is reluctant to allow its own rates to rise much ahead of the ECB, as it fears that raising rates ahead of the ECB may create unwanted HUF appreciation. In that sense, ECB guidance on the first hike is important to the NBH. Overall, the NBH's desire to keep policy loose and pro-growth is so strong that our best guess is that the bank would aim to lag the ECB, rather than lead it. Q6: How does the NBH view the latest market volatility With inflation in the vicinity of the 3%Y target and the EM backdrop having turned more challenging, the NBH has had to adopt a more cautious tone. At present, we think that the bank views the move in both HUF and interest rates as almost entirely speculative, and therefore not yet needing a strong response in the form of a change in policy. Note that in a chart pack published with the June rate decision, the NBH showed that speculative positions of foreign investors against HUF increased sharply between March and June. But at the same time, we note that foreign investors' ownership of HGBs has not changed much. This, combined with the fact that turnover in the FX market has been fairly limited in recent weeks, likely explains why the NBH views the recent HUF underperformance as being driven by short-term speculative bets, rather than a fundamental reassessment of Hungary's macro risk. This matters for two reasons. First, the NBH is therefore much more likely to sit and wait, rather than reacting to speculative bets on the currency. We think that the bank is inclined to dismiss this phenomenon as temporary, at least until it sees some capitulation in positioning among long-term bond investors, or more serious FX weakness which puts the CPI target in jeopardy. Second, it follows that the (related) Exhibit 3:Foreigners have held onto their HGB exposure in recent weeks 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 2014-01-022015-01-062016-01-082017-01-052018-01-10 Non-resident holdings of HUF gov't securities, billion HUF Source: AKK, Morgan Stanley Research4。。。。。。