Easing Not Exhausted

Despite a month of forex market jitters, the climate remains supportive of monetary easing across CE-4. This is certainly the case in Poland. Interest rates are still high at 6.00% and the FRA markets are pricing in 50bps of cuts over the next three months. Industrial output growth slowed sharply in March to 3.7% y-o-y from 2.3% in February. Although this was largely due to base effects and may not signify the onset of a prolonged slowdown, we do see real GDP growth falling this year to 4.7% from 6.9% in 2004. As such, the economy, while in solid shape, could benefit from the additional stimulus of a rate cut. Furthermore, falling inflation strengthens the case for monetary easing, as CPI slowed to 3.4% y-o-y in March from 3.6% in February. Nevertheless, there are factors that could limit the scale of monetary easing in the short-term. While current zloty volatility is unlikely to prove a long-term trend, the bank may be wary of doing anything that could push the unit - currently PLN4.1727/EUR - below the key support level of PLN4.2000/EUR, which would have fewer disinflationary benefits. Going forward, risks could arise from fiscal loosening ahead of the elections in the autumn. Moreover, although there is a general expectation that fiscal reform will resume following the election, it is worth noting that Law and Justice party, which has just inched into the lead in the opinion polls, is campaigning on a pledge to boost social spending significantly. Moderate easing should continue in Hungary , even though March CPI registered a slight uptick to 3.3% y-o-y in March from 3.2% in February. The bank is unlikely to undertake a major change in policy direction on the basis of one-month's inflation data, and National Bank of Hungary (NBH) policy board member Gabor Oblath believes that there is room for rates to fall further from their current high level of 7.75%. However, the extent of monetary easing over the medium-term is less certain, especially after new Finance Minister Janos Veres' assertion that Hungary is not yet ready for extensive fiscal reform. We would suggest that with the 2005 full-year budget deficit target already 71% complete, fiscal reform is long overdue. Until the twin deficits are tackled, carry is set to continue being the main factor supporting the forex and bond market, which will curtail the room for monetary easing and keep rates relatively high for the foreseeable future. Further easing could risk putting the emphasis firmly on the twin deficits and trigger hot money outflows. Disinflation in Slovakia has created room for around 50bps of rate cuts in the coming months. CPI fell to 2.3% y-o-y in March from 2.6% the month before and the central bank expects inflation to end the year below the its 3.0-4.0% target range. The bank has also indicated that it does not regard the current bout of koruna volatility as risky, and shares our view that appreciation could resume in the medium-term. Nevertheless, a case exists for pausing monetary easing until the unit stabilises, as it has proved particularly vulnerable to the latest bout of risk aversion, having fallen in value by 5.6% to its current level of SKK39.59/EUR. Furthermore, price pressures have not retreated entirely. Industrial wage growth climbed 21.5% y-o-y in February from 9.9% y-o-y in January, and we expect real GDP growth to maintain last year's buoyant growth rate of 5.5%. There may be room for further easing in the Czech Republic too, but there are also compelling reasons why they should stay where they are for the time being. Admittedly, CPI is now just 1.5% y-o-y and retail sales growth is a mere 1.0% y-o-y. However, at their current level of 2.00%, Czech interest rates have converged with the eurozone, and the bank may refrain from divergence for as long as possible. Czech National Bank Governor Zdenek Tuma has also expressed concern about a rapid rise in household borrowing and said that the emergence of price pressures in the future is "impossible to predict". Uncertainties are also present on the political front. Although a deal has been hammered out that is likely to restore the three-party ruling coalition and avert early elections, tensions may well persist between the Christian Democrats and the Social Democrats. Consequently, the potential for renewed political noise, combined with the backdrop of forex market volatility, could also militate against rate cuts in the months ahead.

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