Considerations for setting the medium-term inflation target

The medium-term inflation target set in summer 2005 and taking effect in January 2007 brings fundamental changes in the Hungarian inflation targeting mechanism. Whereas formerly the government and the central bank used to set a new inflation target each year, a 3-percent medium-term target will enter into effect from the above date onwards. The transition to the new mechanism was not self-evident, as both the former and the new regimes have their specific drawbacks and benefits. This article discusses these issues, arguing that the advantages of the new regime are far more important than its drawbacks and exceed the benefits of the old regime. In the current state of the Hungarian economy, a 3-percent inflation target can be deemed optimal on the medium term. The reason why it is slightly higher than the inflation targets of the countries with advanced economies is the catching-up nature of the Hungarian economy. The Hungarian inflation target is reviewed every three years, since the optimal level of inflation may change, and will probably decrease in Hungary over time. Another important date, when the inflation target will again be reviewed, will be Hungary’s prospective entry into the common European exchange rate mechanism (ERM-II). The article also explains that the inflation target has been defined as a point target, which, given the situation of Hungary, is more favourable than a target band, which is employed by many other countries.