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Estimating the reaction function for Hungarian monetary policy

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Hidi J.

Kozgazdasagi Szemle (Economic Review)

2006

vol. 53

issue 12

1178-1199

Analysis based on reaction functions, a popular tool in monetary policy, can be used for two purposes: on the one hand, they can provide a reference value for the actual interest-rate level, and on the other, they allow characterization of the relationship between interest rates and other macro variables. This study discusses both issues for Hungary in the recent period of inflation targeting. Overall it can be concluded that the Taylor rule fits the Hungarian interest rate series well, although taking into account the openness of the economy, this fit can be improved further by using other reaction functions. Significant deviations of the actual interest rate from the levels implied by reaction functions can be explained by the presence of the exchange-rate band or by swings of the risk premium. With the relationship between interest rates and other macro variables, the role of the output gap in determining interest rates seems insignificant. The effect of inflationary expectations and the exchange rate turns out to be significant, and their relationship with interest rates is similar to those found in other countries. When inflation expectations are higher, interest rates increase more. The role of the exchange rate depends on the time horizon: at monthly frequency, interest rates are sensitive to exchange-rate changes. But at quarterly frequency, which is closer to the central bank's policy horizon, the exchange rate only has an indirect effect on interest rates through its effect on inflationary expectations.

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1 Kozgazdasagi Szemle (Economic Review)

1 2006

1 Hidi J.

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Estimating the reaction function for Hungarian monetary policy