How should the central bank react to the VAT increase?

With a VAT increase, prices go up in the economy as businesses pass through the effects of the tax rise. Technically, this means that the consumer price index increases for one year; this is called the first-round effect. If, however, the expectations of economic agents are not completely rational or the inflation target of the central bank is not credible, there is a risk that agents will consider the additional inflation attributable to the VAT hike to be persistent and future inflation to remain higher than it was before the VAT rise in the long term. In this case, the effect of the tax hike may also be present in the form of higher wages and expectations. This latter, indirect process is called the second-round effect. According to the international best practice of central banks, monetary policy disregards the one-off price level increasing shocks, but attempts to offset second-round effects on inflation. However, in countries where the inflation target had not been met before the VAT rise, central banks are more inclined to also react to direct price level increasing measures, and risks relating to the anchoring of expectations are highly articulated in the communication of the central bank. As inflation in Hungary has persistently been above the target, there is a possibility that the recurring cost shocks may become incorporated into inflation expectations and may cause stronger second-round effects.