Session 2: Monetary Policy under Uncertainty

Financial conditions arrive together. Central banks must assess how they affect the inflation outlook, expectations and transmission of policy. The discussion will also consider how communication and policy frameworks can remain effective when the outlook is unusually difficult to read. The session will be moderated by Eddie Yue, Chief Executive of the Hong Kong Monetary Authority. Joining him are Governor Taleh Kazimov of the Central Bank of the Republic of Azerbaijan, Governor Yannis Stournaras of the Bank of Greece, and Governor Mihály Varga of the Central Bank of Hungary. Please welcome the moderator and the panelists.

Thank you. First of all, I would like to express my sincere gratitude to the Central Bank of the Republic, especially to my colleague Governor Fatih Karahan, to you for moderating our panel, and to this distinguished panel. Thank you for joining us. First of all, everyone, all the colleagues whom I met during these times think that we are in a very good situation because of the energy prices as a commodity exporter. But before answering the question on the AI part, I would like to mention about how energy price volatility affects us and the current situation very briefly. So we are affected by the high energy prices in two ways. First, definitely, this is our current account balance, and we have for the first six months a surplus of 12.4% of our GDP. The second is, of course, our international reserves, foreign currency reserves, which reach approximately 120% of our GDP. So this is the positive side, definitely. But as a central bank, we care more about price stability, and here on the negative part we see the impact of inflation because of the high energy prices. I will explain why, because if you exclude commodity exports — when I'm saying commodities, oil and gas — when you exclude oil and gas exports from our trade balance, we are net importers, and 80% of the goods and services which we import come from oil and gas dependent countries, the countries who are importing the energy resources. So when prices are high, those trading partners have inflation increase, and that inflation is imported to Azerbaijan. So this is a very brief overview of how the current situation impacts on our macroeconomic situation. When it comes to AI, definitely for the government this is — I mean, it's not even a question of will, it's a must to focus in this direction, and we have several state programs on digitalization of government services, AI transformation of the implementation, transformation of AI in the country. And we see, for recent years, particularly for this year, that this sector is growing very rapidly. Investment in the information technology and communication sector increased by 49% if you compare these eight months with the previous year's eight months. Growth of the information technologies and communication sector is 10% by the end of August, and we see tech products and services exports increase to 2.5. Another niche which is very important, I think I need to underline that, the benefits of having energy resources, oil and gas. So we can say that we have quite cheap energy resources, conventional resources, but we also have the alternative resources capacity for wind and solar energy. So offshore capacity is 157 gigawatts. For onshore we have 135 gigawatts capacity potential for alternative energy. And using this potential, we would like — we already started to dig in investments for hyperscale data centers and cloud service providers, and the government is at the finalizing stage having global partners to run hyperscale data centers, particularly for AI.

Thank you, Eddie. Thank you, Fatih Karahan, Governor of the Central Bank of Turkey, for inviting us here to this very important conference, and especially these days. I would say that things are quite different now compared to many years ago. Geopolitical tensions, tariffs, conflicts, now bond yields — it's a completely different environment than the ones we have been used to in the past. And also we should not forget that Europe is a net energy importer compared to other jurisdictions. So we suffer most because of the terms of trade effects compared to other continents and countries. Having said so, we said this morning that we have shown resilience, the euro area has resilience. Okay, inflation is up, but growth is perhaps slightly better than we had expected. In Europe, inflation increases even more. Greece grows at about 2% the last two, three years, and it's expected to continue to grow at about 2%, so about double the rate of the euro zone, mostly because of investment demand. Don't forget that Greece had passed through a very serious crisis, and it's catching up now. We call it a success story, and I think it is a success story. In 2019, investment had fallen to 11% of GDP, very low. Now it's 18% of GDP. So you can imagine the huge rise in investment in the previous years is both private investment, foreign direct investment, but also the European Union RRF, the Recovery and Resilience Fund, which has helped in Greece and investment. So overall, growth has not been affected by the events I have described. Inflation has been affected. Greece has a positive output gap. The rest of Europe still has a negative output gap. So this explains mostly the difference between inflation in Europe. Let's take the last month, September available data. In the euro zone it was 3.8%, in Greece it was 5.1%. So it's because of the excess demand. One of the reasons is tourism, actually, as you have described. Tourism and shipping, they are going well in Greece, and I hope they will continue because it depends on how long this crisis will last. So every year tourism exhibits record levels. This year is going to be the best for many years despite the crisis. Shipping does the same, as you know. Shipping revenues follow freight rates, and the energy crisis and the geopolitical conflicts have increased freight rates, but this is for the moment. We don't know if it continues. So overall, Greece is doing well despite the crisis. And incidentally, I can say that Greece can give many lessons because of the crisis it has suffered. And the main lesson for today is that even the most serious economic problem can be resolved if you have the will and the willingness and the technical know-how to apply the right policies. So right policies can solve even the most difficult problem, and Greece is perhaps the best example of it.

Thank you, Eddie. First of all, I also would like to thank for the invitation, and I thank especially Governor Fatih Karahan for the warm hospitality in this wonderful city. So in answering the question, I would like to briefly touch upon three different points, naturally, of course. So from the Hungarian perspective, firstly, as Eddie mentioned, Hungary is a small and open energy importing economy, therefore is highly exposed to the global energy price shocks. So commodity prices have become much more volatile in the 2020s. This triggered significant inflationary pressures, challenging central banks. So Hungary is amongst the most affected countries. The energy intensity of our economy is the fifth highest in the European Union, and the share of fuel within household consumption is the third highest. So these structural issues resulted in the rapid rise of inflation, one of the highest levels in the European Union between November 2022 and October 2023. The peak was over 23, 24% inflation in January 2023. So however, Hungary is now much more prepared for supply shocks than it was in 2022. The current account balance is now in surplus, and inflation is much lower than at the start of the energy crisis in 2022. In September it was 1.6% rate of inflation. So it's much below the tolerance band of the central bank. So energy demand in our economy has also fallen considerably since 2021 due to the adjustment carried out by both households and businesses. It is also worth noting that external cost pressures are also lower. Domestic inflation is much more moderate than in early 2022. Secondly, as a result, despite the volatile external environment, underlying Hungarian inflation has been moderate this year. The CPI measure has remained below the 3% target considering the price dynamics by removing the volatile food and energy elements. Core inflation has been hovering around 2%. And inflation is also expected to remain moderate the rest of the year. Low imported inflation has been supported by the early 2026 appreciation of the Hungarian currency, the forint, which is offsetting higher energy prices. Just as importantly, household inflation expectations dropped. I believe that holding the expectations is key to achieving the inflation target on a sustained basis. And last but not least, furthermore, some fiscal measures would also help to reduce the burden of the higher energy prices on households. For example, our government introduced a support scheme for diesel car owners in the form of fixed monthly payments for most diesel car owners. The impact of such a measure is minimal on the government deficit. It supports those households that suffer more from the increasing energy prices, and importantly, it doesn't create fuel supply problems. So in comparison, Hungary introduced temporary petrol price caps in 2021 and also earlier in 2026. This is a highly tempting solution in periods of rapid inflation, as price caps immediately reduce the inflationary pressure. Yet they may also lead to supply problems and, as a result, could become inflationary on a longer horizon. So the overall picture is most favorable — there are some most favorable developments.

Thank you. I will split this question into two parts. One is regarding inflation, high inflation and moderate growth, let's call it like this, and second, what we are doing on monetary policy. So as I said in the previous — can you hear me now? Yes. So we are, as being net importers, excluding oil and gas exports, we are very much hit by the inflation of our trading partners, and our current inflation, August figures, is 5.7%. And we expect that it will reach the upper band of our target by the end of this year, 6.1. So our target is 4% with plus-minus two upper and lower boundaries. But starting from 2027, we expect that under current circumstances, by the middle of 2028, we will hit our target of 4%. But for the last three years, we managed to keep our inflation at the level — average inflation at the level of 4.4%. So we were managing within our target boundaries. Our main anchor in terms of monetary policy is our stable currency regime. Yes, our currency is stable since 2017. And we are trying to withhold importing import inflation by strengthening the nominal effective exchange rate. Yes. So when it comes to economic development, due to optimization of our fiscal policy, this year we have moderate growth in GDP, it's 1.2%. But when we're looking at non-oil GDP, it's showing 2.1% growth. Yes, it's still below its potential. We expect to reach it, and we're targeting to have it at 4.5% by the end of 2027. But again, this is mainly because of the fiscal policy and budget optimization, if to be precise. When it comes to what should be the response from a monetary perspective to such supply shocks, I think my firm belief is that we should not react immediately in terms of changing some monetary framework, but the operational framework should always be under revision by the central bank, and we are also doing it. It doesn't mean that we will revise or change something, but the operational framework of our monetary policy is constantly under revision by the team, and of course we are in very strong collaboration with the sector to see what should be changed in our operational framework to achieve our prime goal of financial stability. But in terms of monetary policy, the stable currency regime will remain as a — thank you.

Thank you. Is it only a supply side shock? That's okay. We had a series of supply side shocks which turned into energy price shocks, but also we have demand shocks. For instance, during COVID, governments intervened to help people. So there was a fiscal expansion. We had an relaxation of the rules of the Stability and Growth Pact. So it was fiscal expansion and monetary expansion to counteract the pandemic. So it was not only a supply side shock. It was also a demand shock. Now it's also a demand shock. Mainly it's a supply side shock translated into energy supply shocks: crude oil, natural gas products, refined products as well, but also we have huge investments in artificial intelligence. We have fiscal expansion in a number of countries in Europe. A number of countries, they have passed the 3% limit of the deficit in the United States, in Japan, in other countries as well. So it's not only a supply side shock. In theory, as I think Chris explained this morning, if it's one supply side shock, we can overlook it and monetary policy can't do anything. But in our case, we have a series of supply side shocks, it's not only one, and also on top of this we have also demand shocks, so monetary policy cannot stay idle. Okay, if it was only one we can overlook it, but now it's a serious supply side shock. Our main question is, do we have second round effects? We don't have second round effects, or at least important second round effects, in Europe. Expectations seem to be well anchored around 2%, especially long-term expectations, survey expectations the same. We have though indirect effects because the rise in energy prices affects the price of plastics, supplies of fertilizers, the price of many other goods. So what matters here first of all is, do we have second round effects? Not seriously. This is good. So we should take this into account and be moderate in our monetary policy tightening. What matters actually is how persistent is the supply side shock, is it being transmitted into the rest of the economy or stays in certain sectors, and will it last? So these are the questions we have. There's huge uncertainty, that's why we have scenario analysis, we have various scenarios. I don't think it makes sense now to say whether we are in the baseline or in the adverse, or it is in between actually in Europe now between the baseline scenario and the adverse scenario. So how do we solve this trade-off? There is a trade-off, yeah, if it's mostly a supply side shock there is the trade-off. We solve it with what we call the reaction function in the euro zone, the ECB's reaction function, which shows what is the outlook for inflation, the dynamics of the underlying inflation, and the transmission mechanism. So by using this reaction function we inform, through our communication policy, markets how we're going to react in this. So we have decided, as you know, to abandon forward guidance because now we have huge uncertainty. It doesn't make any sense to pre-commit to a path of interest rates. But we have adopted a more flexible approach, we call it — Olaf explained it this morning — framework guidance. So along with framework guidance and the scenario analysis and the reaction function will inform markets. So markets now can form expectations in a rational way.

Thank you, Eddie. As you mentioned earlier, this period, the 2020s, are remarkably characterized by uncertainty. It's not a question. Even amidst speculative pressures, the central bank can contribute to macroeconomic stability by focusing on price stability, the core mandate, achieving and maintaining price stability. So uncertainty undermines long-term investment and growth. Not a question why, high and volatile inflation erodes purchasing power and distorts price signals. In such a situation, bringing inflation back to target supports predictability, which is the very basis of sustainable economic growth. So monetary policy cannot eliminate the underlying causes and direct consequences of supply shocks. Nevertheless, large and consecutive supply shocks can potentially affect inflation expectations, and therefore prevention of second round effects is highly important. So as a result, the thorough measurement and monitoring of inflation expectations have become an increasingly important aspect of conducting monetary policy. In my opinion, the central bank reaction functions do remain essential and effective. However, they need to be applied flexibly. In an unpredictable global environment, central banks must also account for tail risks and consider alternative scenarios alongside the baseline outlook. Communicating these scenarios offers the public vital insights into the monetary policy reaction function. Also, it is worth reviewing the monetary policy framework from time to time. So, according to the National Bank of Hungary's recently concluded review, most elements of our monetary policy framework are in line with international best practices. However, on the basis of nominal and real economy convergence of the Hungarian economy to the euro zone, the Monetary Council decided to reduce the inflation target. So the decision brings the National Bank's inflation target in line with regional practices and closer to the ECB target. The new 2.5% target will come into effect over the monetary policy horizon on 1 January 2028.

Yes. Forward guidance was useful when inflation was very low and we were at the effective lower bound with negative interest rates, if you remember, in the euro zone, minus 0.5%. In that case we didn't have the ability to continue reducing the interest rates because it was an effective — very technical discussion to do it now — but there was an effective lower bound. So we did QE, quantitative easing, and we used forward guidance to affect expectations so that markets believed that we're going to follow a specific interest rate path or keep interest rates very low. Now these conditions are not present. Inflation is above the targets. Interest rates are not close to the effective lower bound. And also we have huge uncertainty. We have a sequence of shocks, demand and supply shocks, and we don't have any visibility on the resolution of this uncertainty. So it doesn't make any sense to pre-commit to a specific interest rate path. Instead, we have used — not what central banks used in the past. Chris might remember the book 'The Secrets of the Temple', right, 1988 by Greider, about the secrecy of the Fed in the past, long before forward guidance. It was secrecy. Central bank governors didn't talk or talked very little. And I remember once one famous Fed governor said, 'If you understood what I said, I have not expressed it correctly.' So, no, now — but lack of communication now, with the independence that we have been granted by governments, wouldn't be right. So we have to be accountable and explain to people what we are doing. So what we have chosen in the ECB, in the place of forward guidance, is framework guidance. What is framework guidance? We explain our reaction function to the public and to the markets. We explain the risks. We are very open. Every member of the Governing Council talks to the press outside the silence periods. So markets know very well what the arguments are for —

The future. Not committing an interest rate path is correct for the reasons I have explained. So we have adopted a meeting-by-meeting approach, but we have given guidance to markets through our communication. And so this is how we have substituted forward guidance with a new framework, which is not the secrets of the temple.

Thank you. Maybe I will expand here. Actually, we are using three tools and we call it a hybrid approach. First, our main anchor is the currency regime and it's stable, and we have two supporting this: our interest rate channel and second, our macroprudential policy. We managed to use three of them in combination for the last three and a half years, and I think due to changes which we have in the financial system and keeping inflation for the last three years within the target boundaries, I think we were pretty successful. So since before 2000, I will elaborate here a little bit. Before 2022, in Azerbaijan, the interest channel existed but never worked. Yes. Since 2022, we changed monetary policy, we started to establish this transmission for our policy. It was the first time when we created the money market, the interbank unsecured indexes, and what we started to realize is that the interest rate channel can be a very good shock absorber for a stable currency regime situation. It can be a very good shock absorber, and for the last two years, we see that the interest rate channel started to impact on interest rates in the market, including the yield curve, including the deposit and credit interest. Third, we achieved it with the help of macroprudential regulation. In Azerbaijan, the central bank is a mega regulator. We're in charge of banking, insurance, investment, capital market, fintech, and payments, so we see the whole picture. And having authority to introduce macroprudential regulation, which we used in 2023, 24, and 24, that was reserve requirements first, definitely, and LCR. We introduced LCR in combination with and we linked it to reserve requirements that supported our targeting of our inflation and creating the new monetary policy.

So, but when we talk about uncertainty, maybe I will share here my thoughts on that. And when we say uncertainty, we think or we say that it's supply chain disruption, AI disruption, climate risks, I don't know, conflict, geopolitical conflicts, and all this stuff. For me, it's not actual uncertainty because we're living in this situation for the last, I don't know, five to six years, including COVID, and it's not uncertainty. And the only certain thing in human life is uncertainty. Yes. So through all of history, every day we live in an uncertain situation. So sometimes we as a central bank, including myself, we're using this uncertainty to bring some drama while we're communicating our decision, and also it's a fair backup in case our projections will not actually meet the actual results after running. But it's okay. I mean, it's normal, it's human. For me, if you're asking me what is uncertainty for me as a central banker, it's if you recall for the last six years, we have a lot of things happened. Yes. And the only thing constant in this life, it's not, I'm not making the bicycle, you know, better. The only constant thing is change. So this speed of change creates uncertainty, and for me, I think the biggest challenge is what will be the gap between the speed of change and the speed of central banks' response to that change. Yes. So as this gap widens, the more problems we will have. So, and the only thing what we as a central bank, and I believe any institution, any government body, and even commercial institution, but when it comes to the central bank, the only thing what we can do is to preserve our main asset. Of course, I think the main assets are human capital, the people who are running the institution. But when you talk about mandate, it's not price stability for a central bank, it's credibility of a central bank. And with the speed of change, this credibility will be under big pressure. Yes. So, what if you ask me where we should focus? Yes. I think three directions. First is central banks should change mindset, corporate culture, I don't know how to say, behavior. What I mean under this, we should move, if I'm not mistaken, Governor Olaf also mentioned that we should move from conservative, yes, risk-averse, slow decision maker to a more modern, agile, data-driven decision maker, and sometimes with courage to make a judgment very fast. Second is we should use more technology. Yes. And I don't mean that we should substitute people with technology. We should use it together, including AI, advanced technologies. And third, this is communication. For me, all these three are acceptable because I came from the commercial sector. Yes. Particularly for communication, we should speak the language of our ultimate beneficiaries, of our message, of our policies, and it's not financial institutions. Yes. We communicate it through financial institutions. We should make our communication very easy. I mean, saying inflation increased because of external factors, it doesn't give anything to the guy who is watching Facebook, yes, or TikTok. As we can say that due to external factors, we have an increase in inflation, we should target our ultimate beneficiary, and this is business and individuals, because yes, in an era without internet, yes, maybe the main target audience was financial institutions, economic professors, and this advanced, let's say, people in terms of the macroeconomy. But nowadays we should deal with Generation Alpha and Beta that is coming. Yes, so that's the biggest challenge. And I forgot to say, when I'm saying about the behavior of central banks, we should look to financial institutions not as an object of our transmission or an object of our supervision. We should change the approach in terms that this is our client, because we, of course, those central banks who are in charge of supervision, yes, within the supervisory policies, but we should maximally support financial institutions because they are the companies, they are the institutions who support our communication, who transmit our communication to the ultimate owners, ultimate beneficiaries of our policies. So we should treat them as a real client, we should support them. So the main uncertainty for me is how we will be responsive to the accelerating speed of change, and second, how central banks will change their behavior, will use their information technology in their day-to-day operation, not relying only on old models. Yes. But also bringing technologies there and simplifying communication.

So in general, the European Central Bank policy shifts directly alter euro yield curves and the regional risk premium. This strongly influences local currency dynamics and cross-border capital flows in small open economies having strong bonds to the euro area. So in this environment, maintaining an appropriate interest rate differential relative to the ECB's benchmark rates helps to preserve the stability of financial markets and anchor inflation expectations. So, however, the optimal size of interest rate differential depends partly on the risk assessment of the country's financial assets. So decreasing risk premium through improving investor sentiment can offer more leeway for monetary policy. Thus, as a small, open, and emerging market economy, monetary policy spillovers from abroad are naturally relevant for us. However, country-specific factors often might play a larger role in influencing the inflation outlook. In the summer, the National Bank of Hungary conducted a short cycle of interest rate cuts despite the uncertain external environment, expectations of rate hikes globally. Domestic factors like the significant improvement in risk assessment of Hungarian financial assets and a favorable inflation outlook made this possible, and it was a successful period during the summer. So consequently, the exchange rate channel is a particularly important channel in the monetary transmission mechanism in Hungary. The pass-through of exchange rate movements into consumer prices has become faster and stronger in recent years compared to the previous decade. This means that global uncertainties and game-changing events in financial markets have become more important from a price stability perspective as well. So sometimes a strong exchange rate channel can be beneficial. Stronger pass-through of the appreciation of the domestic currency, the forint, to prices stemming from the improving risk assessment has significantly dampened the inflationary effects of the rising external cost environment. As a result, the domestic inflation rate has indicated subdued price dynamics for an extended period, even as we witness accelerating price increases worldwide. So regarding the interest rate channel, there are some structural factors which weaken, in the case of Hungary, loans to GDP share is around 15% both in the households and in the corporate sector, which are low levels in international comparison. In the latest high inflation period, in line with the external experience, the change in deposit rates largely fell behind the increase in the policy rate or in the lending rates, especially in the household sector. So among the main causes were the lack of competition, the high liquidity position of the banking sector, and the generally low financial literacy of the households. So in addition, the share of lending with fixed interest rates is quite high in the household sector, which means less sensitivity to the policy rate changes. And in the previous high inflation period, the government implemented several measures, which was mentioned earlier, which temporarily affected the pass-through of the policy rate to bank rates, for example, subsidized loans and interest rate caps. In my opinion, finding the optimal level of coordination between economic policies is essential.